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Resource-Based Theory

Creating and Sustaining Competitive Advantage


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Resource-Based
Theory
Creating and Sustaining Competitive
Advantage

Jay B. Barney
Delwyn N. Clark

1
3
Great Clarendon Street, Oxford ox2 6
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1 3 5 7 9 10 8 6 4 2
PREFACE

Resource-based theory is an efficiency-based explanation of sustained


superior firm performance. The purpose of this book is to provide a
comprehensive overview of resource-based theory from its origins to the
current state-of-the-art research. The book starts by describing the history
of resource-based theory, its fundamental tenets, how it has and can be
applied, and outlines ongoing efforts to extend and refine this theory of
persistent performance differences.
The content of the book is organised into four parts. Part I includes
three chapters which provide an introduction to resource-based theory. In
Chapter 1, the historical development of resource-based theory is outlined,
and key terms in the theory are defined and discussed. Chapter 2 examines
the relationship between strategic factor markets and competitive advan-
tages in product markets. Chapter 3 focuses on the attributes of resources
and capabilities that enable some to be sources of sustained competitive
advantage.
Part II applies resource-based theory in analyzing the ability of four
organizational resources and capabilities to be sources of sustained com-
petitive advantage. The resources examined include organizational cul-
ture (Chapter 4), trustworthiness (Chapter 5), human resource practices
(Chapter 6), and information technology (Chapter 7).
Part III shifts the unit of analysis from the competitive implications
of specific organizational resources to the analysis of the competitive
implications of specific strategic alternatives. Three corporate strategies—
vertical integration (Chapter 8), diversification (Chapter 9), and mergers
and acquisitions (Chapter 10)—are examined.
Part IV presents an overview of the current state of resource-based
theory. A summary of the empirical research testing resource-based theory
within strategic management and other management disciplines is pro-
vided in Chapter 11. Finally, opportunities for extending and expanding
resource-based theory in future are proposed in Chapter 12.
vi PREFACE

Many of the chapters in this book are based on previously published


materials taken from a wide variety of articles, book chapters, and books
published over the last twenty years. Some chapters draw on several such
sources, while others have been written specifically for this book. In each
case, care has been taken to use the common language, definitions, and
assumptions that have emerged in resource-based theory over these twenty
years. In this sense, the contents of this book represent both the history of
resource-based theory and its current state of development. It also helps
define what we think are some of the important next steps in the evolution
of this theoretical perspective.

Acknowledgements

The authors would like to thank the following for permission to repro-
duce published material: co-authors of paper extracts including: Asli
Arikan (Chapters 1 and 11), Margie Peteraf (Chapter 1), Mark Hansen
(Chapter 5), Patrick Wright (Chapter 6), Francisco Mata and William
Fuerst (Chapter 7), Gautam Ray and Waleed Muhanna (Chapter 7), Heli
Wang (Chapter 9), and Tyson Mackey (Chapter 11); and publishers includ-
ing Blackwell Publishers (Chapters 1, 3, and 11), the Academy of Manage-
ment (Chapters 4 and 9), Elsevier (Chapter 11), INFORMS (Chapter 2),
Pearson (Chapter 9), the Management Information Systems Research Cen-
ter (Chapter 7), and Wiley (Chapters 1, 5, 6, 7, and 10).
Special thanks also to many exceptional colleagues, students and friends
who have contributed to numerous interesting and insightful conversa-
tions on resource-based theory over the years; to Kathy Zwanziger for
excellent editorial support; to Oxford University Press, UK, for professional
assistance with this publication; to Fisher College of Business, The Ohio
State University, and the University of Waikato Management School, for
institutional support; and to our families for being a constant source of
love and inspiration.
A special note on the cover. After rejecting several suggested covers,
Professor Barney happened across a piece of work by a young, but very
promising artist/engineer—Isaac McFadden. Isaac’s agents negotiated hard
PREFACE vii

for the rights to this brilliant multi-media piece, but in the end, they agreed
to let his work be included on the cover of this book. We both take great
pride in introducing Isaac’s talent to the world.
Jay B. Barney and Delwyn N. Clark
October 2006
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CON TE N TS

PREFACE v
LIST OF FIGURES x

PART I RESOURCE-BASED THEORY

1 The strategic management question and the emergence


of resource-based theory 3
2 Strategic factor markets and competitive advantage 31

3 Firm resources and sustained competitive advantage 49

PART II RBT AND ORGANIZATIONAL CAPABILITIES

4 Culture as a source of sustained competitive advantage 79


5 Trust as a source of sustained competitive advantage 93

6 Human resources as a source of sustained competitive advantage 121


7 Information technology as a source of sustained competitive advantage 143

PART III RBT AND ORGANIZATIONAL STRATEGIES

8 Resource-based theory and vertical integration 161


9 Resource-based theory and corporate diversification 185

10 Resource-based theory and mergers and acquisitions 205

PART IV RBT: THE RESEARCH FRONTIER

11 Resource-based theory: empirical research 221

12 The future of resource-based theory 247

BIBLIOGRAPHY 265
INDEX 307
LIST OF FIGURES

1.1 Ricardian rents and the economics of land with different


levels of fertility 9
1.2 Prices allocate the value created 26
1.3 Greater economic value supports the generation of rent 27
1.4 The chain of logic from resources to rents 28
3.1 The relationship between traditional ‘SWOT’ analysis, the
resource-based model, and models of industry attractiveness 50
3.2 The relationship between resource heterogeneity and immobility,
value, rareness, imperfect imitability, and organization, and
sustained competitive advantage 69
9.1 The determinants of the optimal scope of a firm 200
Part I
Resource-Based Theory
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1 The strategic
management
question and the
emergence of
resource-based
theory∗

The field of strategic management, like other social science disciplines, is


organized around a central research question. That question is: ‘Why do
some firms persistently outperform others?’ This question does not pre-
sume that there will always be persistent performance differences between
firms. Sometimes firms do not outperform others; sometimes performance
differences are short lived. Rather, this question only suggests that it may
be the case that, in some situations some of the time, persistent perfor-
mance differences will exist between firms. It is these differences in firm
performance that strategic management scholars seek to understand.
At the broadest level, two explanations about why some firms persis-
tently outperform other firms have been developed in the literature. The
first, and older of the two, was originally articulated by Porter (1979, 1981)
and draws heavily on the structure-conduct-performance (SCP) paradigm
in industrial organization economics (Bain 1956). This explanation focuses
on the impact that a firm’s market power has on the ability of a firm to
raise prices above a competitive level (Porter 1981). If entry into industries
where firms are exercising market power is restricted by various barriers,
then these performance differences can persist (Bain 1956).

∗ This chapter draws from Peteraf and Barney (2003) and Barney and Arikan (2001).
4 RESOURCE-BASED THEORY

The second explanation of why some firms persistently outperform


other firms focuses less on industry structure and market power, and more
on the differential ability of some firms to more effectively and efficiently
respond to customer needs (Demsetz 1973). This explanation draws heav-
ily on neoclassical price theory (Foss and Knudsen 2003) and suggests that
if it is costly for less efficient and effective firms to copy more efficient
and effective firms, that the superior performance of these latter firms can
persist (Rumelt 1984).
These two explanations of persistent heterogeneity in firm performance
are not necessarily contradictory. Market power explanations apply in
some settings, for example, when a firm is operating in an oligopoly (Gale
1972) or as a regulated monopolist (Bain 1941). Efficiency explanations
apply in other settings, for example, when the level of competition in
an industry is relatively high and when industry level barriers to entry
either do not exist or are not effective (Cool, Dierickx, and Jemison 1989).
Efforts to apply efficiency models of sustained superior performance in
oligopoly or monopoly situations are likely to lead to poor firm perfor-
mance; efforts to apply market power models of sustained superior perfor-
mance in more competitive industrial settings are likely to lead to poor firm
performance.
While not denying the importance of understanding the role of market
power in explaining the existence of sustained superior firm performance
in some industrial settings, this book largely ignores these explanations.
Rather, this book focuses on efficiency theories of sustained superior firm
performance and especially on one particular efficiency theory—resource-
based theory. In this sense, the purpose of this book is to describe the
history of resource-based theory, its fundamental theoretical tenets, how
it has been and can be applied, and the ongoing efforts to extend and refine
this theory of persistent performance differences.

Some theoretical antecedents of


resource-based theory

Resource-based theory, like any theory, draws on prior theoretical work


in developing its predictions and prescriptions. In the case of resource-
based theory, important prior theoretical work comes from at least
POSITIONING RESOURCE-BASED THEORY 5

four sources: (a) the traditional study of distinctive competencies, (b)


Ricardo’s analysis of land rents, (c ) Penrose (1959), and (d) the study of the
antitrust implications of economics. Each of these prior theories is briefly
discussed in turn.

TRADITIONAL WORK ON DISTINCTIVE COMPETENCIES


For sometime now, scholars have tried to answer the question, ‘Why
do some firms persistently outperform others?’ Before more economic
approaches to answering this question began to dominate this discussion
(beginning with Porter 1979), this effort focused on what were known
as a firm’s distinctive competencies. Distinctive competencies are those
attributes of a firm that enable it to pursue a strategy more efficiently and
effectively than other firms (Learned et al. 1969; Hrebiniak and Snow 1982;
Hitt and Ireland 1985, 1986).
Among the first distinctive competencies identified by those trying to
understand persistent performance differences between firms was general
management capability. General managers are managers in firms who have
multiple functional managers reporting to them. Typically, general man-
agers have full accounting profit and loss responsibility in a firm. And when
they do not have this responsibility, general managers are likely to lead cost
centers. Whether profit center or cost center managers, general managers
can have a significant impact on the strategies a firm decides to pursue and
on the ability of a firm to implement the strategies it develops.
Given the impact that general managers can have on a firm’s strategy,
it naturally follows that firms that have ‘high-quality’ general managers
will usually outperform firms that have ‘low-quality’ general managers. In
this context, choosing high-quality general managers is the most important
strategic choice that can be made by a firm, and training high-quality gen-
eral managers is the most important mission of business schools (Gordon
and Howell 1959; Pierson 1959).
The emphasis on general managers as distinctive competencies was
important not only in the field of strategic management, but in closely
related fields as well. For example, through the early 1950s, the study of
business history was confined largely to the study of individual business
people and firms. Traditionally, business historians were reluctant to gen-
eralize beyond individual biographies and firm histories to discuss broader
6 RESOURCE-BASED THEORY

trends in the economy that may have led to different forms of business
organization, let alone the efficiency characteristics of these different orga-
nizational forms. For business history, like strategic management, explana-
tions of the growth and success of firms were no more than the biographies
of those who created and managed those firms (Chandler 1984).
Indeed, there is little doubt that general managers can have a very sig-
nificant impact on firm performance (Mackey 2006). There continues to
be a tradition of leadership research that examines the skills and abili-
ties of leaders and documents their impact on the performance of firms
(Finkelstein and Hambrick 1996). Some of the best of this work focuses
on general managers as change agents and emphasizes the impact that
these ‘transformational leaders’ can have on a firm’s performance (Tichy
and Devanna 1986). Most observers can point to specific general managers
who have been instrumental in improving the performance of the firms
within which they work. The continuing popularity of books, articles, and
seminars (e.g. Bennis 1989, 2003; Covey 1989; Kanter, Stein, and Jick 1992;
Pfeffer 1994; Kotter 1996; Ulrich 1997; Kotter and Cohen 2002; Zenger and
Folkman 2002; Finkelstein 2003) that describe the attributes of individuals
that enable them to become leaders in their firms is a testament to the
popularity of the belief that leaders, and in particular, general managers,
are the most important determinant of a firm’s performance.
Unfortunately, there are some very important limitations of this general
management approach to explaining persistent performance differences
among firms. First, even if one accepts the notion that general management
decisions are the most important determinants of firm performance, the
qualities and characteristics that make up a high-quality general manager
are ambiguous and difficult to specify. In fact, the qualities of a ‘good’
general manager are just as ambiguous as the qualities of good leaders
(Yukl 1989). In the case literature, general managers with widely different
styles are shown to be quite effective. For example, John Connelly, former
president of Crown Cork & Seal, was intensely involved in every aspect
of his organization (Hamermesh and Rosenbloom 1989). Other successful
chief executive officers (CEOs) tend to delegate much of the day-to-day
management of their firms (Stogdill 1974). Yet both types of general man-
agers can be very effective.
Second, general managers are an important possible distinctive com-
petence for an organization, but they are not the only such competence.
POSITIONING RESOURCE-BASED THEORY 7

An exclusive emphasis on general managers as an explanation of supe-


rior performance ignores a wide variety of firm attributes that may be
important for understanding firm performance. For example, it may be
the case that a firm possesses very highly skilled general managers but lacks
the other resources it needs to gain performance advantages. Or it may
be the case that a firm has other resources that enable it to gain per-
formance advantages, even though it does not have unusual managerial
talent. In the end, general managers in organizations are probably similar
to baseball managers: they receive too much credit when things go well and
too much blame when things go poorly.
A sociologist named Phillip Selznick was among the first scholars to
recognize that general management skill was only one of several distinctive
competencies that a firm might control. In a series of articles and books,
culminating in his book Leadership and Administration (Selznick 1957),
Selznick examined the relationship between what he called institutional
leadership and distinctive competence.
According to Selznick, institutional leaders in organizations do more
than carry out the classic general management functions of decision-
making and administration. In addition, they create and define an orga-
nization’s purpose or mission (Selznick 1957). In more contemporary
terms, institutional leaders help create a vision for an organization around
which its members can rally (Finkelstein and Hambrick 1996; Collins and
Porras 1997). Institutional leaders also organize and structure a firm so
that it reflects this fundamental purpose and vision. With this organization
in place, Selznick suggests, institutional leaders then focus their attention
on safeguarding a firm’s distinctive values and identity—the distinctive
vision of a firm—from internal and external threats. This organizational
vision, in combination with organizational structure, helps define a firm’s
distinctive competencies—those activities that a particular firm does better
than any competing firms.
Selznick did not go on to analyze the competitive or performance impli-
cations of institutional leadership as a distinctive competence in any detail.
However, it is not difficult to see that firms with distinctive competencies
have strengths that may enable them to obtain superior performance, and
that leaders as visionaries and institution builders, rather than just as
decision-makers and administrators, may be an important source of this
performance advantage (Selznick 1957).
8 RESOURCE-BASED THEORY

Selznick’s analysis of distinctive competence has much to recommend


it, but it has limitations as well. Most important of these is that Selznick’s
analysis focuses only on senior managers (his institutional leaders) as the
ultimate source of competitive advantage for a firm, and on a single tool
(the development of an organizational vision) that senior managers can use
to create distinctive competencies. Although these are important possible
explanations of performance differences across firms, they are not the only
possible such explanations.

RICARDO’S ANALYSIS OF LAND RENTS


Research on general managers and institutional leaders as possible expla-
nations of differences in firm performance focuses exclusively on top man-
agers, but the next major influence on the evolution of resource-based
theory—Ricardo’s analysis of land rents—traditionally included little or
no role for managers as possible sources of superior performance. Instead,
David Ricardo was interested in the economic consequences of the ‘orig-
inal, unaugmentable, and indestructible gifts of Nature’ (Ricardo 1817).
Much of this early work focused on the economic consequences of owning
land.
Unlike many factors of production, the total supply of land is relatively
fixed and cannot be significantly increased in response to higher demand
and prices. Such factors of production are perfectly inelastic, since their
quantity of supply is fixed and does not respond to price changes. In
these settings, it is possible for those that own higher-quality factors of
production with inelastic supply to earn an economic rent. As suggested
earlier, an economic rent is a payment to an owner of a factor of pro-
duction in excess of the minimum required to induce that factor into
employment.
Ricardo’s argument concerning land as a factor of production is sum-
marized in Figure 1.1. Imagine that there are many parcels of land suit-
able for growing wheat. Also suppose that the fertility of these different
parcels of land varies from high fertility (low costs of production) to low
fertility (high costs of production). The long-run supply curve for wheat
in this market can be derived as follows: at low prices, only the most fertile
land will be cultivated; as prices rise, production continues on the very
POSITIONING RESOURCE-BASED THEORY 9

Price Price Price


MC
MC
D ATC
S ATC

P*

S D

q* q1 q2

(A) (B) (C)


Market supply and Performance of firm Performance of firm
demand, market with less fertile land with more fertile land
quantity (q*), and
market-determined
price (P*)

Figure 1.1. Ricardian rents and the economics of land with different levels of
fertility

fertile land and additional crops are planted on less fertile land; at still
higher prices, even less fertile land will be cultivated. This analysis leads
to the simple market supply curve presented in panel A of Figure 1.1.
Given market demand, P ∗ is the market-determined price of wheat in this
market.
Now consider the situation facing two different kinds of firms. Both
of these firms follow traditional profit-maximizing logic by producing
a quantity (q ) such that marginal cost equals marginal revenue. How-
ever, this profit-maximizing decision for the firm with less fertile land (in
panel B of Figure 1.1) generates zero economic profit. On the other hand,
the firm with more fertile land (in panel C of Figure 1.1) has average total
costs less than the market-determined price and thus is able to earn an
economic rent.
In traditional economic analysis, the economic rent earned by the firm
with more fertile land should lead other firms to enter into this market, to
obtain some land and begin production of wheat. However, all the land that
can be used to produce wheat in a way that generates at least zero economic
profits given the market price P ∗ is already in production. In particular,
there is no more very fertile land left, and fertile land (by assumption)
cannot be created. This is what is meant by land being inelastic in supply.
Thus the firm with more fertile land and lower production costs has a
10 RESOURCE-BASED THEORY

higher level of performance than farms with less fertile land, and this
performance difference will persist, since fertile land is inelastic in supply.
Of course, at least two events can threaten this sustained performance
advantage. First, market demand may shift down and to the left. This
would force firms with less fertile land to cease production, and it would
also reduce the economic rent of the firm with more fertile land. If demand
shifted far enough, this economic rent may disappear altogether.
Second, firms with less fertile land may discover low-cost ways of
increasing their land’s fertility, thereby reducing the performance advan-
tage of the firm with more fertile land. For example, firms with less fertile
land may be able to use inexpensive fertilizers to increase their land’s
fertility, and they may be able to reduce their production costs to be closer
to the costs of the firm that had the more fertile land initially. The existence
of such low-cost fertilizers suggests that though land may be in fixed supply,
fertility may not be. If enough firms can increase the fertility of their land,
then the rent originally earned by the firm with the more fertile land will
disappear, and firms competing in this market can expect to earn only zero
economic rents.
Traditionally, most economists have implicitly assumed that relatively
few factors of production have inelastic supply. Most economic models
presume that if prices for a factor rise, more of that factor will be pro-
duced, increasing supply and ensuring that suppliers will earn only normal
economic rents. However, resource-based theory suggests that numerous
resources used by firms are inelastic in supply and are possible sources of
economic rents. Thus although labor per se is probably not inelastic in
supply, highly skilled and creative laborers may be. Although individual
managers are probably not inelastic in supply, managers who can work
effectively in teams may be. And although top managers may not be
inelastic in supply, top managers who are also institutional leaders (as
suggested by Selznick and others) may be. Firms that own (or control)
these kinds of resources may be able to earn economic rents by exploiting
them.
One issue that Ricardo did not examine but which becomes very impor-
tant in resource-based theory is: ‘How did farms with more fertile land
end up with that land?’ Or, more precisely, ‘What price did farms with
more fertile land pay for that land?’ Resource-based theory suggests that
if the price that farmers pay to gain access to more fertile land anticipates
POSITIONING RESOURCE-BASED THEORY 11

the economic rents that that land can create, then the value of those rents
will be reflected in that price, and even though it may appear that farms
with more fertile land are outperforming farms with less fertile land, this
is not the case. This argument, originally developed by Barney (1986a), is
discussed in more detail in Chapter 2.

PENROSE
In 1959, Edith Penrose published a book titled The Theory of the Growth
of the Firm. Penrose’s objective was to understand the process through
which firms grow and the limits of growth. Traditional economic models
had analyzed firm growth using the assumptions and tools of neoclassical
microeconomics (Penrose 1959). Most important of these, for Penrose,
was the assumption that firms could be appropriately modeled as if they
were relatively simple production functions. In other words, traditional
economic models assumed that firms simply observed supply and demand
conditions in the market and translated these conditions into levels of
production that maximized firm profits (Nelson and Winter 1982).
This abstract notion of what a firm is, had, and continues to have utility
in some circumstances. However, in attempting to understand constraints
on the growth of firms, Penrose (1959) concluded that this abstraction was
not helpful. Instead, she argued that firms should be understood, first,
as an administrative framework that links and coordinates activities of
numerous individuals and groups, and second, as a bundle of productive
resources. The task facing managers was to exploit the bundle of produc-
tive resources controlled by a firm through the use of the administrative
framework that had been created in a firm. According to Penrose, the
growth of a firm is limited (a) by the productive opportunities that exist
as a function of the bundle of productive resources controlled by a firm,
and (b) the administrative framework used to coordinate the use of these
resources.
Besides looking inside a firm to analyze the ability of firms to grow,
Penrose made several other contributions to what became resource-based
theory. First, she observed that the bundles of productive resources con-
trolled by firms could vary significantly by firm—that firms, in this sense,
are fundamentally heterogeneous even if they are in the same industry.
12 RESOURCE-BASED THEORY

Second, Penrose adopted a very broad definition of what might be con-


sidered a productive resource. Where traditional economists (including
Ricardo) focused on just a few resources that might be inelastic in supply
(such as land), Penrose began to study the competitive implications of
such inelastic productive resources as managerial teams, top management
groups, and entrepreneurial skills. Finally, Penrose recognized that, even
within this extended typology of productive resources, there might still
be additional sources of firm heterogeneity. Thus in her analysis of entre-
preneurial skills as a possible productive resource, Penrose observed that
some entrepreneurs are more versatile than others, some are more ingen-
ious in fund-raising, some are more ambitious, and some exercise better
judgment.

THE ANTITRUST IMPLICATIONS OF ECONOMICS


As a field of study, economics has always been interested in the social
policy implications of the theories it develops. One of the most impor-
tant ways that economics has been used to guide social policy is in the
area of antitrust regulation. Based on the conclusion that social welfare
is maximized when markets are perfectly competitive, economists have
developed various techniques for describing when an industry is less than
perfectly competitive, what the social welfare implications of this imper-
fect competition are, and what remedies, if any, are available to enhance
competitiveness and restore social welfare (Scherer 1980).
One of the most obvious ways that an industry may be less than per-
fectly competitive is if that industry is dominated by only a single firm
(the condition of monopoly) or by a small number of cooperating firms
(the condition of oligopoly). In both these settings, according to traditional
economic analyses, prices will be higher than what would exist in a com-
petitive market, and thus social welfare will be less than what would be the
case in that more competitive market.
This approach to analyzing social welfare and antitrust developed into
the ‘structure-conduct-performance’ (SCP) paradigm mentioned earlier in
this chapter (Bain 1956). The SCP paradigm suggests that the structure of
a firm’s industry defines the range of activities that a firm can engage in—
so-called conduct—and, in turn, the performance of firms in that industry.
Firms that operate in industries with structures that are different from the
POSITIONING RESOURCE-BASED THEORY 13

perfectly competitive ideal in important ways may have conduct options


that will enable them to obtain levels of performance that reduce social
welfare in significant ways. In the extreme, this view of the determinants
of firm performance suggests that any persistent superior performance
enjoyed by a firm must, by definition, reflect noncompetitive firm conduct
that is antithetical to social welfare.
Beginning in the early 1970s, a small group of antitrust scholars began
to question the SCP and related approaches to antitrust regulation. Among
the first of these was Harold Demsetz. In 1973, Demsetz published an arti-
cle in the Journal of Law and Economics that argued that industry structure
was not the only determinant of a firm’s performance. Even more funda-
mentally, Demsetz (1973) argued that a firm earning persistent superior
performance could not be taken as prima facie evidence that that firm
was engaging in anticompetitive activities. Indeed, anticipating resource-
based theory, Demsetz argued that some firms might enjoy persistent
performance advantages either because they are lucky or because they are
more competent in addressing customer needs than other firms. Demsetz
(1973: 3) argues

Superior performance can be attributed to the combination of great uncer-


tainty plus luck or atypical insight by the management of a firm . . . Even though
the profits that arise from a firm’s activities may be eroded by competitive
imitation, since information is costly to obtain and techniques are difficult to
duplicate, the firm may enjoy growth and a superior rate of return for some
time . . .
Superior ability also may be interpreted as a competitive basis for acquiring a
measure of monopoly power. In a world in which information is costly and the
future is uncertain, a firm that seizes an opportunity to better serve customers
does so because it expects to enjoy some protection from its rivals because
of their ignorance of this opportunity or because of their inability to imitate
quickly.

While developed in the context of discussions of antitrust regulation,


Demsetz clearly anticipates some important tenets of resource-based the-
ory. It is interesting that Demsetz develops his arguments as an alternative
to SCP-based theories of antitrust. And since Porter (1979, 1980) traces the
theoretical roots of his work back to the SCP paradigm, in an important
sense, Demsetz also anticipates the theoretical debates that have emerged
between resource-based theory and the Porter framework.
14 RESOURCE-BASED THEORY

Thus we see that resource-based theory, far from emerging out of


nowhere to become an important explanation of persistent superior firm
performance in the field of strategic management, has deep theoretical
roots in both economics and sociology. These theoretical streams have
been united and modified to develop what has become resource-based
theory.

The development of resource-based theory

EARLY RESOURCE-BASED CONTRIBUTIONS1


Perhaps the first resource-based theory publication in the field of strate-
gic management identified as such was by Wernerfelt (1984). Ironically,
Wernerfelt’s resource-based arguments did not grow directly from any of
the four theoretical traditions identified above. Rather, Wernerfelt’s argu-
ment is an example of dualistic reasoning common in economics. Such
reasoning suggests that it is possible to restate a theory originally developed
from one perspective with concepts and ideas developed in a complemen-
tary (or dual) perspective. For example, in microeconomics, it is possible
to develop economic theories of decision-making using either utility the-
ory, revealed preference theory, or state-preference theory; in finance, it
is possible to estimate the value of an investment using the Capital Asset
Pricing Model or Arbitrage Pricing Theory. Wernerfelt (1984) attempted
to develop a theory of competitive advantage based on the resources a firm
develops or acquires to implement product market strategy as a comple-
ment or dual of Porter’s theory (1980) of competitive advantage based on a
firm’s product market position. This is why Wernerfelt (1984) called his
ideas the resource-based ‘view’—since he was simply viewing the same
competitive problem described by Porter (1980) from the perspective of
the resources a firm controls.
This approach to developing a theory of competitive advantage supposes
that the portfolio of product market positions that a firm takes is reflected
in the portfolio of resources it controls. Competition among product mar-
ket positions held by firms can thus also be understood as competition
among resource positions held by firms. In principle, for every concept
that enables the analysis of the competitiveness of a firm’s product market
POSITIONING RESOURCE-BASED THEORY 15

(e.g. barriers to entry), there should exist a complementary concept that


enables the analysis of the level of competition among resources controlled
by different firms (e.g. barriers to imitation).
One of Wernerfelt’s primary contributions (1984) was recognizing that
competition for resources among firms based on their resource profiles
could have important implications for the ability of firms to gain advan-
tages in implementing product market strategies. In this way, Wernerfelt
anticipated some of the critical elements of resource-based theory as it
developed in the 1990s.
In the same year that Wernerfelt (1984) published his paper, Rumelt
(1984) published a second resource-based paper in a book of readings
coming out of a conference on strategic management. While these papers
addressed similar kinds of issues, they did not refer to each other. Where
Wernerfelt (1984) focused on establishing the possibility that a theory of
firm performance differences could be developed in terms of the resources
that a firm controls, Rumelt began describing a strategic theory of the
firm, that is, a theory explaining why firms exist that focused on the ability
of firms to more efficiently generate economic rents than other forms of
economic organization. At its most general level, such a theory would
suggest the conditions under which firms, as an example of hierarchical
governance (Williamson 1975, 1985), would be a more efficient way to
create and appropriate economic rents than other forms of governance,
including markets. Rather than firms existing as efficient ways to minimize
the threat of opportunism in transactions—as suggested by the transac-
tions cost theorists (Williamson 1975)—Rumelt (1984) was exploring the
rent generating and appropriating characteristics of firms.
This theme of linking rent generation, transactions cost, and governance
emerges much later, in the work of Conner and Prahalad (1996), Grant
(1996), Liebeskind (1996), Kogut and Zander (1996), and Spender (1996),
in efforts to develop a resource-based theory of the firm.2 It also antici-
pates a very important issue that may ultimately serve as a theoretical link
between resource-based theories of firm performance and transactions cost
theories of governance. In particular, both theories point to the importance
of transaction-specific investments as independent variables that explain
different dependent variables. For resource-based theorists, transaction-
specific or firm-specific investments can be thought of as resources that
are among the most likely to have the ability to generate economic rents
16 RESOURCE-BASED THEORY

(Barney 2001a). For transactions cost theorists, transaction-specific invest-


ments create problems of opportunism that must be resolved through
governance choices. Teece (1980) brings these two ideas together explicitly
by arguing that the kinds of relations among businesses that are most
likely to be a source of economic profits for firms pursuing a corporate
diversification strategy are also the kinds of relations that will be difficult
to manage through nonhierarchical forms of governance. Thus, for Teece,
resource-based theories and transactions cost theories, together, constitute
a theory of corporate diversification.
The strategic theory of the firm that Rumelt (1984) develops has many
of the attributes that will later be associated with resource-based theory.
For example, Rumelt defines firms as a bundle of productive resources and
he suggests that the economic value of these resources will vary, depend-
ing on the context within which they are applied. He also suggests that
the imitability of these resources depends on the extent to which they
are protected by ‘isolating mechanisms’. He even develops a list of these
isolating mechanisms and begins to discuss the attributes of resources that
can enhance their inimitability.
The third resource-based article published in the field of strategic man-
agement is Barney (1986a). Similar to Wernerfelt (1984), Barney (1986a)
suggests that it is possible to develop a theory of persistent superior firm
performance based on the attributes of the resources a firm controls. How-
ever, Barney (1986a) moves beyond Wernerfelt (1984) by arguing that such
a theory can have very different implications than theories of competitive
advantage based on the product market positions of firms. Thus, Barney
(1986a) begins a shift from what might be called the resource-based view
toward what is currently called resource-based theory.
Barney (1986a) introduces the concept of strategic factor markets as
the market where firms acquire or develop the resources they need to
implement their product market strategies.3 He shows that if strategic fac-
tor markets are perfectly competitive, the acquisition of resources in those
markets will anticipate the performance those resources will create when
used to implement product market strategies. This suggests that, if strategic
factor markets are perfectly competitive, even if firms are successful in
implementing strategies that create imperfectly competitive product mar-
kets, those strategies will not be a source of economic rents. Put differently,
the fact that strategic factor markets can be perfectly competitive implies
POSITIONING RESOURCE-BASED THEORY 17

that theories of imperfect product market competition are not sufficient


for the development of a theory that explains persistent performance dif-
ferences between firms. This, of course, contradicts one of the central
tenants of Porter’s theory of industry attractiveness—that the ability of
firms to enter and operate in attractive product markets is an explanation
of persistent superior firm performance. In the extreme, Barney’s argument
suggests that if strategic factor markets are always perfectly competitive, it
is not possible for firms to earn economic rents.
Of course, strategic factor markets are not always perfectly competitive.
Barney (1986a) suggests two ways that such markets can be imperfectly
competitive: First, in the face of uncertainty, firms can be lucky and,
second, it may be the case that a particular firm has unusual insights
about the future value of the resources it is acquiring or developing in a
strategic factor market. Barney (1986a) concludes his paper by suggesting
that the resources a firm already controls are more likely to be sources
of economic rents for firms than resources that it acquires from external
sources.
Dierickx and Cool (1989) extended Barney’s argument (1986a) by
describing what it is about the resources a firm already controls that may
make it possible for that resource to generate economic rents. Following
Rumelt’s discussion (1984) of isolating mechanisms, Dierickx and Cool
(1989) suggest that resources that are subject to time compression disec-
onomies (what others [Arthur 1989] have called path dependence), that are
causally ambiguous, that are characterized by interconnected asset stocks,
or that are characterized by asset mass efficiencies are less likely to be sub-
ject to strategic factor market competition than other kinds of resources.
Many of the attributes of a firm’s resources that make them not subject to
strategic factor market competition identified by Dierickx and Cool (1989)
are later discussed and applied by Barney (1991b).
Together, these four papers—Wernerfelt (1984), Rumelt (1984), Barney
(1986a), and Dierickx and Cool (1989)—outline some of the basic prin-
ciples of resource-based theory. These papers suggest that it is possible to
develop a theory of persistent superior firm performance using a firm’s
resources as a unit of analysis. These papers also describe some of the
attributes that resources must possess if they are to be a source of sus-
tained superior firm performance—Rumelt’s concepts (1984) of value and
isolating mechanisms and Barney’s notion (1986a) that resources already
18 RESOURCE-BASED THEORY

controlled by a firm are more likely to be a source of economic rents than


other kinds of resources. They also suggest that it is the bundle of unique
resources possessed by a firm that may enable a firm to gain and sustain
superior performance.
Of course, a great deal of work has followed these initial four papers.
For example, Barney (1986b) developed a resource-based explanation of
why an organization’s culture can be a source of sustained competitive
advantage (to be discussed further in Chapter 4), and Barney (1988)
applied the logic developed in Barney (1986a) to mergers and acqui-
sitions to show that strategic relatedness, per se, was not sufficient for
bidding firms to earn economic rents from acquiring target firms (to be
discussed further in Chapter 10). Conner (1991) explored the relationship
between resource-based theory and other traditions in microeconomics.
Building on Rumelt (1984), she also began to explore some of the theory
of the firm implications of resource-based logic. Castanias and Helfat
(1991) showed how the creation and appropriation of economic rents
aligned the interests of a firm’s managers and equityholders and thus
how resource-based logic helped address incentives problems identified in
agency theory (see Alchian and Demsetz 1972; Jensen and Meckling 1976).
Barney (1991b) published a paper that outlined the basic assumptions of
resource-based logic and how those assumptions could be used to develop
testable assertions about the relationship between a firm’s resources and its
competitive advantages (to be discussed further in Chapter 3).4 Rumelt
(1991) published an empirical paper that showed that firm-level effects
explained more variance in firm performance than either corporate or
industry level effects, a result consistent with resource-based logic and a
result that contradicted earlier published work that showed that industry
effects were a more important determinant of firm performance than firm
effects (Schmalensee 1985; Wernerfelt and Montgomery 1986). Hansen
and Wernerfelt (1989) published a paper that demonstrated that the char-
acteristics of a firm’s organizational culture had a more significant impact
on its performance than the attributes of the industry within which it
operated—results that also were consistent with resource-based expecta-
tions. Peteraf (1993) published a paper that thoroughly grounded resource-
based logic in microeconomics, and Mahoney (1993) published an article
that compared and contrasted resource-based logic with other theories
of competitive advantage. Grant (1996) published an article that, among
POSITIONING RESOURCE-BASED THEORY 19

other things, began to explore the managerial implications of resource-


based logic.
Together, these and many other papers created the foundation of what
has become known as resource-based theory. The major assumptions,
assertions, and predictions of this body of theory are examined in detail
in subsequent chapters of this book.

Parallel streams of ‘resource-based’ work

As this resource-based theory was developing, scholars in other research


traditions were developing theories of competitive advantage that had
numerous similarities to resource-based logic but were developed largely
independent of the work cited earlier. Two of the most important of these
parallel streams were the theory of invisible assets (Itami 1987), and work
on competence-based theories of corporate diversification (e.g. Prahalad
and Bettis 1986; Prahalad and Hamel 1990).

ACCUMULATING AND MANAGING INVISIBLE ASSETS


As described by Itami (1987: 12), invisible assets are information-based
resources such as technology, customer trust, brand image, and control of
distribution, corporate culture, and management skills. For Itami, physical
(visible) assets must be present for business operations to take place but
invisible assets are necessary for competitive success. Invisible assets are
the real sources of competitive power and adaptability because they are
hard and time-consuming to accumulate, can be used in multiple ways
simultaneously, and are both input and outputs of business activity. People
are both accumulators and producers of invisible assets.
Itami classifies information as being environmental, corporate, and
internal. Environmental information flows from the environment to the
firm, creating invisible assets related to the environment such as pro-
duction skills and customer information. Corporate information, such
as corporate reputation, brand image, corporate image, and marketing
know-how, flows from the firm to its environment. Internal information,
such as corporate culture, morale of workers, and management capability,
originates and terminates within the firm. In each category, the amount of
20 RESOURCE-BASED THEORY

information gathered, its nature, as well as the channels through which it


is gathered, are all invisible assets.
Invisible assets are accumulated either directly—where a firm takes
explicit actions such as choosing a technology for research and
development—or indirectly—where assets are accumulated as by-products
of daily operations. According to Itami (1987), the accumulation and
maintenance of invisible assets indirectly through operations can take more
time than direct efforts, but the results of this process are more reliable. For
example, word-of-mouth customer appreciation is much more effective
than a television advertisement in convincing potential customers to buy
a firm’s products. However, this is not to suggest that the direct route
has to be completely abandoned, but rather that a balance between these
two methods of invisible asset accumulation is necessary.
Given the role of both visible and invisible assets of the firm, firms
should choose projects that are within the firm’s area of expertise and
appropriate to its skills (Itami 1987: 159). However, firms intending to
grow have to create deviations from this ideal fit to accumulate new invis-
ible assets. Firms that choose to accumulate new invisible assets need
to understand that they usually will not be able to compete in a new
business as effectively as they have competed in their original market.
However, this temporary loss of effectiveness may be necessary if a firm
is to continually develop new invisible assets it can use to grow and
prosper.
Of course, Itami’s emphasis on the intangible and invisible aspects of a
firm directly parallels resource-based theory. However, rather than simply
focusing on how resources can explain a firm’s current performance, Itami
examines the impact of these invisible assets on a firm’s diversification
efforts. This links Itami’s work very closely with the work on the core
competence of the organization.

COMPETENCE THEORIES OF CORPORATE DIVERSIFICATION


With respect to competence-based theories of corporate diversification, it
has already been suggested that Teece (1980) was among the first scholars
to begin to apply resource-based logic to the problem of corporate diver-
sification. In an effort that paralleled Teece’s work, Prahalad and his col-
leagues (Prahalad and Bettis 1986; Prahalad and Hamel 1990) also began
POSITIONING RESOURCE-BASED THEORY 21

developing an approach to understanding corporate diversification that,


while never explicitly labeled as a ‘resource-based approach’ had a great
deal in common with resource-based logic as it was developing through the
1990s. Where most previous corporate strategy work had focused on the
importance of shared tangible assets across the multiple businesses a diver-
sified firm had begun operating in (see, e.g. Rumelt 1974; Montgomery
1979), Prahalad began emphasizing the potential importance of sharing
less tangible assets across businesses and the role that this sharing could
play in creating value through diversification.
In Prahalad and Bettis (1986: 491), these shared intangible assets were
called a firm’s dominant logic. They define a firm’s dominant logic as
‘a mindset or a worldview or conceptualization of the business and the
administrative tools to accomplish goals and make decisions in that busi-
ness.’ Clearly, dominant logic, as an economic justification for corporate
diversification, emphasizes intangible, even cognitive, bases for diversifi-
cation. Certainly, one of the advantages of such bases of diversification
compared to more tangible bases is that competing corporations would
have more difficulty imitating these intangible bases of diversification.
Prahalad and Hamel (1990) extended the concept of dominant logic in
a very influential paper that defined the notion of a corporation’s ‘core
competence’. Prahalad and Hamel (1990: 82) defined a corporation’s core
competence as ‘the collective learning in the organization, especially how
to coordinate diverse production skills and integrate multiple streams of
technologies.’ Here again, Prahalad and his coauthors focus on intangible
rather than tangible assets as a basis for competitive advantage in choosing
and implementing corporate strategy.
While developed independently of resource-based logic, this emphasis
on the economic value of the intangible is common to both Prahalad’s
work and resource-based theory as it was developing in the 1990s. Indeed,
since these early contributions by Prahalad, Bettis, and Hamel, most schol-
ars that have either further developed the ideas of a firm’s ‘dominant logic’
(Grant 1988) or core competence or tested the empirical implications of
these ideas have approached this work in ways that are consistent with
resource-based logic (e.g. Wernerfelt and Montgomery 1988; Robins and
Wiersema 1995). Indeed, resource-based theories of corporate diversifica-
tion, as is shown in Chapter 11, have been one of the most popular ways to
empirically test resource-based logic.5
22 RESOURCE-BASED THEORY

Additional comments about resource-based theory

Before continuing this discussion, a few additional comments about


resource-based theory are needed. These concern the confusion about
terms describing factors of production controlled by a firm and the
definition of competitive advantage in resource-based theory. These clari-
fications will greatly simplify the discussion in the remainder of this book.

TERMS TO DESCRIBE FACTORS OF PRODUCTION CONTROLLED


BY A FIRM
First, there continues to be some ongoing confusion about the terms used
to describe factors of production controlled by a firm. Through the 1990s,
various authors have tried to develop typologies of these tangible and
intangible assets in an effort to suggest that different types of assets can have
different competitive effects for firms. For example, Wernerfelt (1984) and
Barney (1991b) simply called these assets ‘resources’ and made no effort to
divide them into any finer categories. Prahalad and Hamel (1990) devel-
oped the concept of ‘core competencies’ and, building on Selznick (1957)
and others, added the term competence to the resource-based lexicon. Stalk,
Evans, and Shulman (1992) argued that there was a difference between
competencies and capabilities, and thus this term (capabilities) was added
to the terminological fray. Teece, Pisano, and Shuen (1997) emphasized the
importance of the ability of firms to develop new capabilities, a perspective
emphasized by their choice of the term ‘dynamic capabilities’. (Note: these
are ‘capabilities that are dynamic’.) Several authors have suggested that
knowledge is ‘the’ most important resource that can be controlled by a firm
and have developed what they call a ‘knowledge-based theory’ of sustained
superior firm performance (see, e.g. Grant 1996; Liebeskind 1996; Spender
and Grant 1996).
In principle, distinctions among terms like ‘resources’, ‘competencies’,
‘capabilities’, ‘dynamic capabilities’, and ‘knowledge’ can be drawn. For
example, in their textbooks, Hill and Jones (1992) and Hitt, Ireland, and
Hoskisson (1997) distinguish between resources and capabilities by sug-
gesting that resources are a firm’s ‘fundamental’ financial, physical, indi-
vidual, and organizational capital attributes, while capabilities are those
POSITIONING RESOURCE-BASED THEORY 23

attributes of a firm that enable it to exploit its resources in implement-


ing strategies. Drawing upon Amit and Schoemaker (1993), Makadok
(2001) defines capabilities as special types of resources that are ‘organi-
zational embedded non-transferable firm-specific resources whose pur-
pose is to improve the productivity of other resources’. Makadok (2001)
notes complementary and substitute effects between ‘resource-picking’
and ‘capability-building’—these are distinct rent-creation mechanisms.
Teece, Pisano, and Shuen’s concept (1997) of dynamic capabilities tends
to focus on the ability of firms to learn and evolve (Lei, Hitt, and Bettis
1996). Among the stream of work exploring this perspective, Eisenhardt
and Martin (2000) define dynamic capabilities as ‘the antecedent orga-
nizational and strategic routines by which managers alter their resource
base—acquire and shed resources, integrate them together, and recombine
them—to generate value-creating strategies.’ General practice suggests that
the concept of competencies is most often applied in the context of a firm’s
corporate diversification strategy. Knowledge is clearly a special case—
albeit an important one—of some of these other terms or concepts.
While these distinctions among types of resources can be drawn and
can be helpful in understanding the full range of resources a firm may
possess, the effort to make these distinctions has had at least one unfortu-
nate side effect: those who have developed new ways to describe a firm’s
resources have often labeled their work as a ‘new’ theory of persistent
superior performance. Thus, the strategic management literature currently
has proponents of ‘resource-based theories of superior performance’, ‘capa-
bility theories of superior firm performance’, ‘dynamic capability theories
of superior performance’, ‘competence theories of superior performance’,
and ‘knowledge-based theories of superior performance’.
While each of these ‘theories’ has a slightly different way of characteriz-
ing firm attributes, they share the same underlying theoretical structure. All
focus on similar kinds of firm attributes as critical independent variables,
specify about the same conditions under which these firm attributes will
generate persistent superior performance, and lead to largely interchange-
able empirically testable assertions. Battles over the label of this common
theoretical framework are an extreme example of a classic academic ‘tem-
pest in a tea pot’—‘full of sound and fury but signifying nothing’.
Given this state of affairs, the following conventions have been adopted
throughout this book. First, the terms resources and capabilities will be
24 RESOURCE-BASED THEORY

used interchangeably and often in parallel. Second, the term core compe-
tence is applied only in discussions of the conception or implementation
of corporate diversification strategies (Prahalad and Hamel 1990).
A variety of authors have generated lists of firm resources, capa-
bilities, and competencies that enable firms to conceive and imple-
ment value-creating strategies (Thompson and Strickland 1983; Hitt and
Ireland 1986; Grant 1991; Hall 1992; Amit and Schoemaker 1993; Collis
and Montgomery 1995; Hitt, Ireland, and Hoskisson 1997). For pur-
poses of this discussion, these numerous possible firm resources can
be conveniently classified into four categories: physical capital resources
(Williamson 1975), financial capital resources, human capital resources
(Becker 1964), and organizational capital resources (Tomer 1987). Phys-
ical capital resources include the physical technology used in a firm, a
firm’s plant and equipment, its geographic location, and its access to raw
materials. Financial capital resources include all a firm’s many revenues,
including its debt, equity, and retained earnings. Human capital resources
include the training, experience, judgment, intelligence, relationships, and
insight of individual managers and workers in a firm. Organizational capi-
tal resources include attributes of collections of individuals associated with
a firm, such as a firm’s culture, its formal reporting structure, its formal and
informal planning, controlling, and coordinating systems, its reputation in
the marketplace, as well as informal relations among groups within a firm
and between a firm and those in its environment.

THE DEFINITION OF COMPETITIVE ADVANTAGE IN


RESOURCE-BASED THEORY
Second, there has also been much debate recently about the dependent
variable in resource-based theory, variously identified as ‘competitive
advantage’, ‘sustained competitive advantage’, and ‘economic rents’. Com-
petitive advantage can be defined as follows:

An enterprise has a Competitive Advantage if it is able to create more economic


value than the marginal (break even) competitor in its product market. (Peteraf
and Barney 2003: 314)

This definition is consistent in spirit with the definition of competi-


tive advantage provided by Barney (1986a, 1991a) and with the usage
POSITIONING RESOURCE-BASED THEORY 25

of this term by Porter (1985). It is consistent, as well with the value-


based approach to competitive advantage presented in Peteraf (2001). It
resembles the value-creation frameworks of Brandenburger and Stuart
(1996) and of Besanko et al. (2000), though it differs in terms of its
reference point. Its precise meaning, of course, depends on a clear defin-
ition of what it means to ‘create economic value’. Thus ‘economic value’ is
defined in concert with the definition of competitive advantage.
The Economic Value created by an enterprise in the course of providing a
good or service is the difference between the perceived benefits gained by the
purchasers of the good and the economic cost to the enterprise. (Peteraf and
Barney 2003: 314)

Several things about this definition are notable. First, it is a net benefits
approach to value creation. It is the benefits produced by a firm’s under-
takings, net of their costs. Chapter 2 of this book focuses on identifying
precisely what the total costs associated with conceiving and implementing
a strategy are.
Second, it is a view of value creation closely aligned with fundamental
economic principles. Value is expressed in terms of the difference between
perceived benefits, or customer willingness-to-pay, on the one hand, and
economic costs on the other. This is, in essence, the same as the economic
concept of total surplus, which equals the sum of the economic rents (pro-
ducer surplus) and customers’ ‘value for the money’ or consumer surplus.
The definition supports the notion that the value that an enterprise creates
has the potential to enhance the welfare of all of its stakeholders. It is
independent of the price of the product, though prices serve to allocate
the surplus (see Figure 1.2).
Third, it emphasizes perceived benefits, suggesting that the perceptions
of consumers, rather than some absolute notion of quality differentials, are
what really matter. This is consistent with a marketing view of how value is
created.
Finally, greater value implies greater efficiency. To create more value than
its rivals, an enterprise must either produce greater benefits for the same
cost or the same benefits for a lower cost. Thus it supports an efficiency
view of resource-based theory.
Taken together, these two definitions (of competitive advantage and of
economic value) provide a precise picture of what a competitive advantage
consists, as well as how it may be achieved, in the most general terms.
26 RESOURCE-BASED THEORY

Perceived ----
benefits (B)

Consumer surplus Value created


(B–C)

Price (P) -----

Producer surplus
Cost (C) -----

Economic cost

Figure 1.2. Prices allocate the value created

Competitive advantage is expressed in terms of the ability to create rela-


tively more economic value. To create more value than its rivals, an enter-
prise must produce greater net benefits, through superior differentiation
and/or lower costs. The benchmark for comparison is the marginal com-
petitor. This implies that a competitive advantage may be held by several or
even many firms in a given industry and suggests that there may be several
different routes to competitive advantage. It simply requires an enterprise
to be a superior value generator, relative to the least efficient competitor
capable of breaking even. An enterprise with competitive advantage need
not be the very best performer in all dimensions.
These definitions can also link competitive advantage to economic rents.
Begin by comparing the situation of two single-business firms competing
in a product market, one of which has a competitive advantage over the
other (see Figure 1.3). For illustrative purposes, we assume that the focal
firm, firm A, creates $180 of economic value for each unit of output that it
provides the market, while its rival, firm B, creates only $150 of value per
unit of output. Note that economic value can be expressed in monetary
terms, since the level of perceived benefits is reflected in the customers’
maximum willingness-to-pay for the good, while economic costs have a
corresponding dollar counterpart.
In this scenario, product price determines how much of the economic
value created by a firm is distributed to customers, in terms of benefits
received over and above their cost to the consumer (price paid). If each
POSITIONING RESOURCE-BASED THEORY 27

Delivered value Total Delivered value Total


$100 economic $100 economic
value value
$180 $150
Residual value Residual value
$80 $50

Rent = $30

Focal firm Rival


VA = $180 VB = $150

Figure 1.3. Greater economic value supports the generation of rent

firm delivers the same level of benefits to consumers, say $100, firm A will
have a pool of residual value that exceeds that of firm B by $30 ($80−$50).
What is residual value? It is what is left over after the consumers have
been allocated a share of the total value. This is the share of total value
that remains to be divided among other claimants, including the firm. In
Figure 1.3, the residual value available to firm A is $80, while firm B has
only $50 of total value left to allocate. Firm A has a positive differential
in residual value of $30 ($80−$50). What does this positive differential in
residual value represent? This, of course, is firm A’s competitive advantage
over firm B, and it provides a protective cushion for A against competition
from B.
To illustrate this, imagine that fierce price competition breaks out in this
product market. Under such conditions, each firm will continue to lower
prices in an effort to attract one another’s customers until prices reach that
point at which one of the firms is no longer willing to supply. For either
firm, that will occur at the point that its residual value dips below zero.
(When the residual pool of value is zero, there is nothing left for the firm
to claim over and above its economic costs. When the residual value is
negative, the firm cannot even recover its costs.) Since B will reach that
point first, B will become the marginal, breakeven competitor and prices
will stabilize. Firm A can continue to produce profitably, due to its cushion
of $30 per unit.
Alternatively, the competition between A and B could take place on the
cost side, through, say, greater advertising or auxiliary services. This kind
of competition will also whittle away at the residual value. Once again, the
28 RESOURCE-BASED THEORY

limit to this competition occurs when the residual value of the least efficient
firm is completely dissipated. That firm again is firm B, leaving A with a
residual of $30 per unit.
This pool of excess residual value is equal to the economic rents attribut-
able to the more efficient factors of firm A. Economic rents are defined as
returns to a factor in excess of its opportunity costs. To understand why it is
possible to view this excess value as a rent, consider a firm that possesses
scarce resources and capabilities that enable it to increase the amount of
economic value it creates. The greater value that is generated by these res-
ources and capabilities is properly viewed as a rent to these scarce critical
resources. It is a ‘return’ to resources in the sense that the production of
the rent is dependent on the efficiency differences among the resources in
use. Without the more efficient resources, the rent would cease to exist. It
is a return above the opportunity costs of resources of this general type, in
that it exceeds the opportunity cost of the marginally productive resources.
It is greater than the return necessary to draw resources of this general
type into production. It is not, however, a return to the resource in the
sense that the resource holder necessarily receives the surplus value. How
this excess residual value is divided among the firm and other claimants
requires further analysis (Peteraf 1993, 2001; Coff 1999). See Figure 1.4 for
a summary of the connection between resources, residual value, and rents.
Of course, the rents that are generated in this manner may be fleeting
and of limited consequence. What is more interesting is whether the rents
can be sustained for some period and whether the firm has any hope of
claiming them in the form of superior profits. These questions are also

Greater value More residual value


Competitive
(net benefits) for same
advantage
delivered value

Lower costs/
higher benefits

Rents

Superior critical
resources

Figure 1.4. The chain of logic from resources to rents


POSITIONING RESOURCE-BASED THEORY 29

addressed by resource-based theory and are discussed later in this book


(Barney 1991a; Peteraf 1993).
Because, in general, it is possible to always link competitive advantages
and economic rents, these two terms are used interchangeably through-
out this book. However, since firms do not necessarily appropriate all
the competitive advantage and economic rents they generate, the term
firm profits will only be applied to that part of the competitive advan-
tage/economic rent a firm is able to appropriate.

Summary and overview book plan

This chapter began by distinguishing between two explanations of sus-


tained superior firm performance—market power explanations and effi-
ciency explanations—and suggesting that the primary topic of this book—
resource-based theory—is an example of the second type of explanation.
Then, four papers that were central to the development of resource-based
theory were introduced, along with a brief discussion of work that evolved
largely independent of resource-based theory as it was developing, but
is very consistent with that theory. The chapter concluded with some
additional remarks—about the different terms used to describe the factors
of production controlled by a firm and about definitions of competitive
advantage and economic rents.
In Chapter 2, the competitive nature of strategic factor markets is
described and discussed. In Chapter 3 the resource-based framework
for evaluating resources as potential sources of sustained competitive
advantage for a firm is outlined. The VRIO framework is presented and
implications of resource-based theory for other business disciplines are
considered.
In Part II, applications of resource-based theory for specific organiza-
tional capabilities are outlined. The potential of four capabilities to be
sources of sustained competitive advantage is considered including: orga-
nizational culture (Chapter 4), trust (Chapter 5), human resource (HR)
practices (Chapter 6), and information technology (IT) (Chapter 7).
In Part III, applications of the resource-based logic to three key strate-
gies are presented. The business and corporate strategies featured include:
vertical integration (Chapter 8), diversification (Chapter 9), and mergers
and acquisitions (Chapter 10).
30 RESOURCE-BASED THEORY

In Part IV, an overview of the current state of resource-based theory is


presented. First, a summary of empirical research that has been conducted
to date based on the resource-based logic is presented in Chapter 11.
Finally, current issues in the development of resource-based theory are
discussed and topics for future development of resource-based theory are
presented in Chapter 12.

NOTES

1. The contributions of, and relationships among, these early resource-based papers
are subject to significant personal interpretation. The history described here is one
interpretation, but certainly not the only interpretation, of those contributions and
relationships. It is also the case that the history described here is not meant to empha-
size some contributions over others. Our view is that, collectively, authors like Barney,
Cool, Dierickx, Hamel, Montgomery, Prahalad, Rumelt, Teece, and Wernerfelt were
all very important in the creation and development of resource-based theory, broadly
interpreted.
2. These ideas were also considered in the economics literature by Richard Langlois
(1992, Industrial and Corporate Change), and Nicolai Foss (1993, Journal of Evolu-
tionary Economics). Contributions by Winter (1987) and Demsetz (1973) are also
important.
3. Barney (1986a) was inspired by a not very well-known paper by Rumelt and Wensley
(1981b) published only in the Proceedings of the Academy of Management. In that
paper, Rumelt and Wensley suggest for the existence of the ‘market for market share’
and argue that if the market for market share is perfectly competitive, that increases
in market share will not lead to increases in firm performance. Rumelt and Wensley
also provide some rigorous empirical support for this assertion. If pressed to describe
the ‘very first’ resource-based paper published, a good argument could be made for
Rumelt and Wensley (1981b).
4. Conner (1991), Castanias and Helfat (1991), and Barney (1991a) were all published
in a special theory forum in the Journal of Management edited by Barney. See Barney
(1991c ). Interestingly, Peteraf (1993) and Teece, Pisano, and Shuen (1997) were both
originally submitted to this special theory forum. Later, they were each published in
the Strategic Management Journal.
5. This said, conversations with Prahalad suggest that he does not see this work as an
example of resource-based logic. Some other of Prahalad’s work, however, is explicitly
cast in resource-based terms, e.g. Conner and Prahalad (1996).
2 Strategic factor
markets and
competitive
advantage∗

Historically, strategic management scholars focused on competitive imper-


fections in product markets to explain persistent differences in firm per-
formance (Porter 1980). This emphasis on product markets is quite rea-
sonable since most economic logic suggests that when product markets
are perfectly competitive, firms in these markets will earn a rate of return
just large enough to cover their cost of capital (Foss and Knudsen 2003).
Logically, it seems to follow that if product markets are competitively
imperfect, then at least some firms in these markets will be able to earn
superior levels of firm performance.
Work on competitive imperfections in product markets has evolved
dramatically over the years. In economics, the number of papers and the-
ories describing the social welfare and other implications of various forms
of competitive imperfections in product markets continues to proliferate
(Segal 1998; Hsu and Wang 2005; Smythe and Zhao 2006). In strate-
gic management, Porter’s ‘five forces framework’ (Porter 1980) describes
competitive imperfections in product markets and how, apparently,
these competitive imperfections can be used to create opportunities to earn
superior returns.
However, that a firm operating in an imperfectly competitive product
market may earn superior levels of performance is not the same thing as
asserting that a firm that implements strategies to create an imperfectly
competitive product market will earn such performance. Whether imple-
menting strategies that create imperfectly competitive product markets
∗ This chapter draws from Barney (1986a).
32 RESOURCE-BASED THEORY

generates superior performance depends on both the revenues created


by these strategies when implemented in product markets and the total
cost of their implementation. This cost includes not just the specific
expenses associated with implementing a particular product market strat-
egy, but also the expenses associated with developing the resources neces-
sary to conceive and implement this product market strategy in the first
place.
A failure to account for the full costs associated with developing strategic
resources can lead firms to overstate the returns generated by implement-
ing their product market strategies. This chapter argues that—except in
specific conditions described here—the total cost of these resources will
often equal their value in creating imperfect product market competition.
In this situation, even if a firm is successful in creating an imperfectly
competitive product market, it will still not be able to earn superior levels
of performance. This suggests that the historical emphasis in the strategic
management literature on competitive imperfections in product markets
is mistaken—such competitive imperfections, per se, may or may not be
a source of superior performance for a firm depending on the cost of the
resources needed to create these imperfections.
The conceptual tool used to discuss the cost of the resources necessary
to conceive and implement a strategy designed to create imperfect product
market competition is the strategic factor market mentioned briefly in
Chapter 1. A strategic factor market is the market where the cost of the
resources used to conceive and implement a firm’s product market strate-
gies is determined. For example, if a firm decides that an acquisition will
help create imperfect competition in a particular product market, it must
enter the market for corporate control. The market for corporate control—
as a strategic factor market—is the market where the cost of using an acqui-
sition to create an imperfectly competitive product market is determined.
If the cost of an acquisition equals the value of the imperfect competition in
a product market this acquisition creates, then it will not generate superior
performance for a firm, even if it actually creates imperfect product market
competition.
All the resources a firm uses to conceive and implement its product
market strategies have, or have had, strategic factor markets associated
with them. Some of these factor markets have been studied in detail, for
example, the market for corporate control. Others have received less
STRATEGIC FACTOR MARKETS 33

theoretical or empirical attention, for example, the market for the cre-
ative capability of entrepreneurs. This chapter examines the relationship
between the competitiveness of these strategic factor markets, the cost of
the resources used by a firm to conceive and implement its product market
strategies, and the ability of those strategies to generate superior levels of
performance.
This discussion is developed in four parts. First, it is shown that when
strategic factor markets are perfectly competitive, the cost of the resources
developed in those markets will equal the value they generate when used
to conceive and implement product market strategies. In such settings,
firms will not obtain competitive advantages, even if they are able to
create imperfect product market competition. Second, it is argued that
firms that expect to obtain economic rents from conceiving and imple-
menting product market strategies must have more accurate expectations
about the value of these resources than other firms competing to develop
them.1 Third, it is also shown that other apparent sources of advan-
tage in developing resources—including the apparent nontradability of
some resources (Dierickx and Cool 1989)—are, in reality, just examples
of these more accurate expectations or a manifestation of a firm’s good
luck. Finally, some ways that firms can become better informed about the
future value of the resources they are developing, including through the
analysis of a firm’s competitive environment and through the analysis of
resources it already controls, are discussed. It is shown that environmen-
tal analysis, by itself, cannot be expected to create the required insights,
while in some circumstances, the analysis of a firm’s current resources
can.

Perfect strategic factor market competition

When firms seeking to develop resources to implement a strategy (strate-


gizers) and those who currently own or control these resources (con-
trollers) have exactly the same, and perfectly accurate, expectations about
the future value of product market strategies before they are actually imple-
mented, then the price of the resources needed to conceive and implement
these strategies will approximately equal their value once they are actu-
ally implemented. This is a conclusion of zero economic rents consistent
34 RESOURCE-BASED THEORY

with all perfect information models of competition where no competitive


uncertainty exists (Lippman and Rumelt 1982). Under these perfect expec-
tation conditions, controllers will never make their resources available if
the full value of those resources is not reflected in their price, nor will
strategizers pay a price for a resource greater than its value in actually
implementing a strategy. In such markets, all rents that could have been
had when the strategy in question was implemented will be anticipated
and competed away.
This conclusion has been examined empirically in several different
strategic factor markets. For example, in the market for corporate control,
it has been well documented that when several firms compete to acquire
the same target to accomplish the same strategic objectives, that the price
of this target will rapidly rise to equal its value in realizing this strategic
objective (Jensen and Ruback 1983). This is one reason that bidding firms
in the market for corporate control usually just break even on their merger
and acquisition strategies.
However, this conclusion also applies to some less well-studied strategic
factor markets. For example, suppose a firm concludes that, in order to
implement its product market strategies, it must enhance the reputation
of its products. Enhancing product reputation is likely to require several
strategic resources—some of which a firm may already possess and some of
which it may need to develop. For example, this firm is likely to have to hire
some quality management professionals, consultants, and employees who
will then have to change this firm’s orientation toward quality. Alterna-
tively, this firm may invest to train some of its current employees in quality
processes. Also, this firm is likely to have to hire or train some research and
development specialists to develop new extensions of its current products,
some marketing people to help position these products in the marketplace,
and sales people who can sell this new type of product. It is also likely to
have to invest in marketing campaigns to help develop its product market
reputation. Of course, to the extent that this firm’s competition becomes
aware of its strategies, they might also begin to assemble the resources
needed to compete in this new way.
The aggregate cost of developing the resources necessary to imple-
ment this new product market strategy—whether through hiring new
employees, training and reassigning current employees, or making other
investments—can be substantial. If those that control each of these
STRATEGIC FACTOR MARKETS 35

resources—be they current or future employees, marketing outlets, and


so forth—anticipate their impact on this firm’s ability to implement its
new strategy, they will each require a payment equal to the value of their
resource for the firm.2 In this setting, the total cost of developing the
resources necessary to implement this product market strategy will equal
the value this strategy creates in the product market, and even if this firm
is successful in creating competitive imperfections in the product market,
it will still not generate competitive advantages.

Heterogeneous expectations in strategic


factor markets

These perfect competition dynamics, and the zero economic rents from
implementing strategies they imply, depend, of course, on the very strong
assumption that all strategizers and controllers have the same, and perfectly
accurate, expectations concerning the future value of strategies. This is
a condition that is not likely to exist very often in real strategic factor
markets.
More commonly, different strategizers and controllers in these mar-
kets will have different expectations about the future value of a strategy.
Because of these differences, some expectations will be more accurate than
others, although strategizers and controllers will typically not know, with
certainty, ahead of time, how accurate their expectations are. When dif-
ferent strategizers and controllers have different expectations concerning
the future value of a strategy, it will often be possible for some strategizers
to generate rents from developing or acquiring the resources necessary to
conceive and implement a product market strategy and then implementing
that strategy.
Consider first the return potential of a strategizer that has more accurate
expectations concerning the future value of a particular product market
strategy than others—either other strategizers or controllers—who might
be interested in this strategy. Two likely possibilities exist. On the one hand,
several others might overestimate a strategy’s return potential. This over-
estimation will typically lead to strategic factor market entry, competition,
and the setting of a price for the relevant strategic resource greater than
the actual value of that resource when it is used to implement a strategy.
36 RESOURCE-BASED THEORY

In this situation, those with more accurate expectations concerning the


return potential of a strategy will usually not enter the strategic factor
market, for they will believe that in doing so they will probably sustain an
economic loss by paying more for a strategic resource than that resource
is worth in implementing a strategy. Thus, in the long run, those with
more accurate expectations will usually be able to avoid economic losses
associated with buying overpriced strategic resources. Those that do pay
for these overpriced resources suffer from the ‘winner’s curse’, that is, the
fact that they successfully develop the resources in question suggests that
they overpaid (Bazerman and Samuelson 1983).
The second possibility facing those with more accurate expectations is
that others, rather than overestimating the return potential of a strategy,
might underestimate that strategy’s true future value. Competition in the
strategic factor market would, in this case, typically lead to a strategic
resource price less than the actual future value of the strategy. In this
situation, those with more accurate expectations about the future value of
the strategy in question will enter the strategic factor market and will pay
the same for the relevant strategic resource as those with less accurate (i.e.
pessimistic) expectations. The cost of these resources will not be any less
to those with more accurate expectations because of the inaccurate expec-
tations held by ill-informed controllers and strategizers. And those with
more accurate expectations will certainly not want to spend more than nec-
essary for these resources. As strategies are implemented, equal competitive
advantages will accrue to all those firms that use the resource in question
to implement this strategy, the well-informed and ill-informed alike.
Thus, on the one hand, those with more accurate expectations con-
cerning the future value of a strategy can avoid economic losses due to
optimistic expectations. On the other hand, these firms will also be able
to anticipate and exploit any opportunities for competitive advantage in
strategic factor markets when they exist. Thus, by avoiding losses and
exploiting rent generating opportunities, these firms, over the long run, can
expect to perform better than firms with less accurate expectations about
the future value of strategies.
Despite the advantages of having a superior understanding of a strategy’s
return potential when acquiring or developing the resources necessary to
implement that strategy, firms without this superior insight can still obtain
STRATEGIC FACTOR MARKETS 37

economic rents when implementing strategies. This can occur when several
of these firms underestimate the potential of a strategy to create economic
value. Because of this underestimation, the cost of the resources necessary
to implement a strategy will be less than the actual future value of the
strategy. In this sense, these firms are able to buy a strategy generated cash
flow for less than the value of that cash flow. However, this competitive
advantage must be a manifestation of these firms’ good fortune and luck,
for the price of the strategic resource developed was based on expectations
about the value-creating potential of that strategy. Value greater than what
was expected is, by definition, unexpected. Unexpected superior economic
returns are just that, unexpected, a surprise, and a manifestation of a firm’s
good luck, not of its ability to accurately anticipate the future value of a
strategy.
Even well-informed firms can be lucky in this manner. Whenever the
actual value created by a strategy is greater than expected returns, the
resulting difference is a manifestation of a firm’s unexpected good fortune.
The more accurate a firm’s expectations about a strategy’s potential, the less
a role luck will play in generating competitive advantages. In the extreme,
though probably very rare case, where a firm knows with certainty the value
potential of a strategy before that strategy is implemented, there can be no
unexpected value created by implementing strategies and thus no financial
surprises. However, to the extent that a firm has less than perfect expec-
tations, luck can play a role in determining a firm’s competitive advantage
from implementing its strategies.

Other apparent competitive imperfections:


the question of tradability

Firms with consistently more accurate expectations concerning the value-


creating potential of strategies they are implementing can expect to enjoy
competitive advantages from implementing their strategies over the long
run. In this sense, differences in firm expectations constitute a strategic
factor market competitive imperfection.
Some have suggested that other differences between firms, besides dif-
ferences in firm expectations, can create competitive imperfections in
38 RESOURCE-BASED THEORY

strategic factor markets. These firm differences, it is thought, can prevent


certain firms from implementing strategies that other firms can imple-
ment. However, close analysis of these other differences between firms
suggests that, to the extent that they constitute competitive imperfections
in strategic factor markets, they are actually a manifestation of different
expectations firms hold about the future value of strategies being imple-
mented. In this sense, differences in firm expectations are the central
source of competitive advantages from developing or acquiring resources
to implement product market strategies.

LACK OF SEPARATION
It has been suggested that a competitive imperfection in a strategic fac-
tor market exists when a small number of firms seeking to implement
a strategy already control all the resources necessary to implement it. In
this setting, these firms do not need to develop the resources necessary
to implement a strategy, and thus apparently stand in some competitive
advantage. An example of this lack of separation might include a uniquely
well-managed firm seeking to implement a low-cost manufacturing strat-
egy. Such a firm already controls most, if not all, the resources necessary to
implement such a strategy and thus is apparently at an advantage compared
to firms that would have to improve their efficiency in order to implement
such a strategy (Porter 1980).
Indeed, Dierickx and Cool’s argument (1989) about the limitations of
strategic factor market theory is a special case of this lack of separation
argument. These authors suggest that many resources that are relevant
in creating imperfect product market competition are not tradable, and
thus not subject to the competitive pressures that exist in strategic factor
markets. Dierickx and Cool (1989) argue that it is this lack of tradability,
not imperfectly competitive factor markets, that enables firms to gain com-
petitive advantages from exploiting their resources in creating imperfectly
competitive product markets.
Of course, there is little doubt that some of the specific resources con-
trolled by a firm are not tradable. For example, one firm cannot sell its
culture to another firm; one firm cannot sell the teamwork among its
managers to another firm. However, that these resources, individually, are
not currently tradable does not mean that they are, and always have been,
STRATEGIC FACTOR MARKETS 39

immune to the competitive pressures of strategic factor markets. This is


true for several reasons.
First, the nontradable assets that a firm currently possesses are, accord-
ing to Dierickx and Cool (1989) and Barney (1986b), developed over long
periods. Indeed, the path-dependent nature of these resources is what
creates the asset interconnectedness that Dierickx and Cool (1989) cite as
one of the major reasons resources may not be tradable. However, over
this period, these resources require investment and commitment in order
to develop. The sum of these costs is what must be balanced against the
revenues that any strategies exploiting these resources may create. If these
costs are greater than this value, then even when firms use these resources
to generate imperfect product market competition, no competitive advan-
tages are generated.
While understanding these costs is important in understanding the full
value created by a strategy, it is not unreasonable to believe that when
these investments in an emerging resource are made, both those controlling
these resources and those looking to invest in these resources will not
have the same and perfectly accurate expectations about their future value.
These resources evolve in ways that are difficult to predict and may enable
the implementation of product market strategies that cannot yet be antici-
pated. That is, the strategic factor markets within which these resources are
developed are clearly imperfect. If strategizers have more accurate expec-
tations about the future value of the resources they are investing in than
controllers and other strategizers, these ‘internally evolved’ resources can
be expected to be sources of competitive advantage. If both strategizers and
controllers underestimate the future value of these resources, competitive
advantages can still be generated, but they will be a manifestation of a firm’s
good luck.
Put differently, that resources are not tradable is not, by itself, the rea-
son resources can be sources of competitive advantage. Rather, it is the
imperfectly competitive factor markets through which these resources are
developed that enable some of these resources to be sources of economic
rents when they are used to implement product market strategies. Thus,
rather than suggesting that strategic factor markets are irrelevant in under-
standing the rent generating potential of resources, Dierickx and Cool’s
argument (1989) identifies several different reasons that a particular strate-
gic factor market may be imperfectly competitive.
40 RESOURCE-BASED THEORY

UNIQUENESS
Others have argued that when only one firm can implement a strategy, then
a strategic factor market competitive imperfection exists (Arthur 1984).
Such a firm may have a unique history or constellation of other assets, and
thus may uniquely be able to pursue a strategy. In such settings, competitive
dynamics cannot unfold, and uniquely strategizing firms could obtain
competitive advantages from acquiring strategic resources and implement-
ing strategies.
However, as before, a firm’s uniqueness is actually a manifestation of
the expectational attributes of previous strategic factor markets. The key
issues become: ‘How did the strategizing firm obtain the unique assets that
allow it to develop the unique strategy it is implementing?’, ‘What price
did this firm have to pay for these assets?’, ‘What price must potential
strategizers pay in order to reproduce this set of organizational assets
so that they can enter and create a competitive strategic factor market?’,
and ‘What are the opportunity costs associated with using these resources
to implement a strategy?’ If the current value of ‘unique’ resources in
implementing a strategy was anticipated at the time those resources
were acquired or developed, then competitive advantages would not
exist.

LACK OF ENTRY
Another source of an apparent competitive imperfection in a strategic
factor market exists when firms that could enter such a market by becom-
ing strategizers do not do so. This lack of entry, however, like separation
and uniqueness is actually a special case of the expectations firms hold
about the future value of strategies. Lack of entry might occur for one
of at least three reasons. First, firms that, in principle, could enter might
not because they are not attempting to act in a profit-maximizing manner.
Second, potential strategizers may not have sufficient financial strength to
enter a strategic factor market and compete for strategic resource. Finally,
firms that, in principle, could enter, may not know how to, for they may not
understand the return generating characteristics of the strategies that cur-
rent strategizers are implementing. Each of these possibilities is considered
in order.
STRATEGIC FACTOR MARKETS 41

Profit maximizing
Firms may abandon profit-maximizing behavior for several reasons. For
example, managers may engage in activities that improve their situation
in a firm, even if those activities do not maximize firm performance
(Jensen and Meckling 1976). Also managers may be subject to a variety
of systematic biases in their decision-making, biases that lead to decisions
that are inconsistent with profit maximization (Busenitz and Barney 1997;
Hirshleifer and Hirshleifer 1998). For these and other reasons, it would
not be surprising to see firms fail to engage in profit-maximizing behavior
some of the time.
However, over the long term, failure to maximize profits can put a firm’s
survival at risk. Moreover, markets typically react whenever a firm veers
from profit maximizing in some significant ways: additional corporate
governance is put into place to reign in agency problems (Jensen 1986) and
unfriendly takeovers replace managers engaging in grossly biased decision-
making (Jensen 1988). In the long run, as these reasons for not engag-
ing in profit-maximizing become less relevant, one possible reason why
a firm may not enter into a strategic factor market remains: Differences
in expectations about the future value of these resources. In this setting,
it is not that firms are abandoning a profit-maximizing motive. Rather,
firms may legitimately disagree how to realize this profit (Alchian 1950).
This disagreement about the value of resources in implementing a product
market strategy is what leads to the lack of entry, not abandoning profit-
maximizing behavior (Shleifer 2000).

Financial strength
Another apparent strategic factor market competitive imperfection exists
when only a few firms have enough financial backing to enter a strategic
factor market and attempt to acquire or develop the resources needed to
implement a product market strategy. Because only a few firms are com-
peting for the relevant strategic resources, perfect competition dynamics
are less likely to unfold, and it may be possible to obtain competitive
advantages from using the acquired resources to implement a strategy.
However, even large differences in financial strength typically reflect
expectational differences in strategic factor markets rather than differ-
ences between the financial strengths of firms, per se. Two ways in which
42 RESOURCE-BASED THEORY

differences in financial strength represent these differences in firm expec-


tations are considered below.
First, in some circumstances, the actual future value of a given strategy
may be the same for whatever firm implements it. In this case, if capital
markets are efficient and well informed concerning the actual future value
of a strategy, then funds will flow to firms wishing to enter a strategic factor
market with anticipated positive economic rents. Sources of capital will
recognize the possibility of these rents and will provide whatever funds
are necessary to ensure that potential strategizers will enter and become
actual strategizers (Copeland and Weston 1979). The same holds true for
controllers. In this way, competition within a strategic factor market will
grow, and any anticipated rents will approach zero. This entry will only not
occur if capital sources are under-informed about the possibility that firms
can obtain competitive advantage from acquiring resources to implement
a strategy. In this situation, potential strategizers and controllers would not
be able to obtain adequate financial backing from under-informed sources
of capital to enter into the strategic factor market. This lack of entry creates
the possibility of competitive advantages for firms that do enter.
However, when are capital sources likely to be under-informed con-
cerning the anticipated returns from implementing a strategy? If potential
strategizers and controllers are as well informed as actual strategizers and
controllers, then it seems likely that the relevant information needed to
generate return expectations falls into the general category of ‘publicly
available information’, and thus would be taken into consideration by
capital sources in making funding decisions (Fama 1970; Copeland and
Weston 1979). Thus, only when actual strategizers and controllers have
expectational advantages over potential strategizers and controllers is it
likely that sources of capital will be under-informed. Thus, in this case,
the lack of entry into a strategic factor market due to insufficient financial
backing is, once again, a reflection of the expectational advantages enjoyed
by some firms in a strategic factor market.
In an efficient capital market, when the actual future value of strate-
gies does not depend on which firm implements them, then the inability
of firms to attract sufficient financial support to enter and compete for
strategic resources must reflect differences in expectations among current
and potentially competing firms. However, sometimes a strategy imple-
mented by one firm will have a greater future value than that same strategy
STRATEGIC FACTOR MARKETS 43

implemented by other firms. In this situation, and under the assumption


of efficient and well-informed capital markets, capital will flow to high-
profit potential firms, while low-profit potential firms may not receive
such financial backing (Copeland and Weston 1979). This lack of financial
backing may prevent entry and thus constitute a competitive imperfection
in a strategic factor market.
However, when can one firm implementing a strategy obtain compet-
itive advantages from doing so compared to other firms implementing
this strategy? The answer must be that this firm already controls other
strategically relevant assets not controlled by other firms (Barney 1991a).
Thus, this firm’s ability to attract financial backing is a reflection of its
unique portfolio of strategically valuable assets and resources, resources
not controlled by other firms. In this sense, lack of entry is simply a
special case of a firm implementing a unique strategy, and the previous
discussion of expectations in strategic factor markets applies here as well. In
short, firms with unique resources that give them the opportunity to gain
competitive advantages are either exploiting special insights they had into
the future value of those resources when those resources were acquired,
or, if they enjoyed no such insights, they are simply enjoying their good
fortune.

Lack of understanding
A final reason entry might not occur is that entrants may not understand
the value generating processes underlying a strategy. Firms form their
return expectations about specific strategies based on their understanding
of the processes by which strategies generate economic value, that is, on
their understanding of the cause and effect relations between organiza-
tional actions and economic value (Lippman and Rumelt 1982). Some of
this understanding may be of the ‘learning-by-doing’ variety (Williamson
1975), and thus not available to potential strategizers and controllers.
When potential entrants do not understand the relationship between orga-
nizational actions and economic value as well as current actors in a strate-
gic factor market, potential entrants are likely to incorrectly estimate the
true value of strategies. If they underestimate this value, then these firms
will not enter the strategic factor market, even when expectations set with
a more complete understanding of a strategy’s value generating processes
44 RESOURCE-BASED THEORY

would suggest that entry was appropriate. Again this lack of entry, and
the competitive imperfection that it might create, reflects the different
expectations firms have about the potential of strategies to be implemented
to generate economic value.

Developing insights into strategic value

Thus far, it has been argued that, in perfectly competitive strategic factor
markets, the cost of the resources necessary to implement a strategy will
approximately equal the discounted present value of that strategy once it
is implemented. It has also been argued that competitive imperfections
in this market can give firms opportunities for obtaining economic rents
when implementing strategies, but that the existence of these imperfections
depends on different firms having different expectations concerning the
future value of a strategy. Other apparent competitive imperfections in
strategic factor markets, including lack of separation, uniqueness, lack of
entry, and different financial resources, in fact, reflect the expectational
characteristics of either current or previous strategic factor markets.
In imperfectly competitive strategic factor markets, firms can obtain
competitive advantages from acquiring the resources necessary to imple-
ment strategies in one or a combination of two ways. First, firms with
consistently more accurate expectations about the future value of a strategy
than other firms can use these insights to avoid economic losses and obtain
economic rents when acquiring or developing resources to implement
strategies. Second, firms can obtain competitive advantages through luck
when they underestimate the true future value of a strategy. Thus, because
luck is, by definition, out of a firm’s control, an important question for
managers becomes, ‘How can firms become consistently better informed
about the value of strategies they are implementing than any other firms?’
Firms that are successful at doing this can, over time, expect to obtain
higher returns from implementing strategies than less well-informed firms,
although, as always, firms can be lucky.
There are fundamentally two possible sources of the informational
advantages necessary to develop consistently more accurate insights into
the value of strategies: the analysis of a firm’s competitive environment and
the analysis of organizational skills and capabilities already controlled by a
STRATEGIC FACTOR MARKETS 45

firm (Stevenson 1976; Lenz 1980; Porter 1980; Barney 1985a, 1985b). Each
of these possibilities is considered below.

ENVIRONMENTAL ANALYSIS
Of these two sources of insights into the future value of strategies, envi-
ronmental analysis seems less likely to systematically generate the expecta-
tional advantages needed to obtain competitive advantage. This is because
both the methodologies for collecting this information (Porter 1980;
Thompson and Strickland 1980) and the conceptual models for analyzing
it (e.g. Henderson 1979; Porter 1980) are in the public domain. It will
normally be the case that firms applying approximately the same publicly
available methodology to the analysis of the same environment will collect
about the same information. And these same firms applying publicly avail-
able conceptual frameworks to analyze this information will typically come
to similar conclusions about the potential of strategies. Thus, analyzing a
firm’s competitive environment cannot, on average, be expected to gen-
erate the expectational advantages that can lead to expected competitive
advantages in strategic factor markets.
Some would suggest that it is not the availability of these environmental
methods of data collection and analysis that is important, but rather the
skill with which these methods are applied. More skilled firms can thus
generate the required expectational advantages through an analysis of the
competitive environment. However, the skills of environmental analysis
can be ‘rented’ from various investment banking and consulting firms, and
thus skill advantages in analyzing competitive environments will typically
only be temporary.
It may be the case that, in the collection of information concerning the
value of a strategy from a firm’s competitive environment, a firm might
‘stumble’ onto some information that gives it an expectational advantage
over other firms. However, if such information was obtained through the
systematic application of environmental analysis techniques, then other
firms besides the firm that has this information would have obtained it
and it would no longer give an advantage. Thus, only if the information
was obtained through nonsystematic means can it give a firm expectational
advantage. However, such information, because it does not result from the
46 RESOURCE-BASED THEORY

systematic application of environmental analysis methodologies, must be


stochastic in origin. Any informational advantages obtained in this manner
must reflect a firm’s good fortune and luck, not their skill in evaluating the
return potential of strategies.

ORGANIZATIONAL ANALYSIS
While firms cannot obtain systematic expectational advantages from an
analysis of the competitive characteristics of their environment, it may be
possible, under certain conditions, to obtain such advantages by turning
inwardly and analyzing information about the assets a firm already con-
trols. Firms will usually enjoy access to this type of information that is not
available to other firms. If these assets also have the potential to be used
to implement valuable product market strategies, and if similar assets are
not controlled by large numbers of competing firms, then they can be a
source of competitive advantage. Examples of the types of organizational
assets that might generate such expectations include special manufacturing
know-how (Williamson 1975), unique combinations of business experi-
ence in a firm (Chamberlin 1933), and the teamwork of managers in a firm
(Alchian and Demsetz 1972). Firms endowed with such organizational
skills and abilities can be consistently better informed concerning the true
future value of strategies they implement than other firms by exploiting
these assets when choosing strategies to implement.

Conclusion

In summary, firms seeking to obtain competitive advantages from imple-


menting product market strategies must have consistently more accurate
expectations about the future value of those strategies when developing
or acquiring the resources necessary to implement them, although firms
can be lucky. Moreover, while it is usually not possible to obtain these
advantages through the analysis of a firm’s competitive environment, firms
can sometimes obtain them when choosing to implement strategies that
exploit resources already under their control.
These conclusions have important implications for the practice and
theory of strategy. For example, firms that do not look inwardly to exploit
STRATEGIC FACTOR MARKETS 47

resources they already control in choosing strategies cannot expect to


obtain competitive advantages from their strategizing efforts. For a strategy
of diversification through acquisition, this implies that firms that fail to
discover unique synergies between themselves and potential acquisitions,
but rather rely only on publicly available information when pricing an
acquisition, cannot expect competitive advantages from their acquisition
strategies, though these firms might be lucky and acquire a firm with
an unanticipated synergy. For a low-cost manufacturing strategy, these
arguments suggest that firms without any special skills at low-cost man-
ufacturing cannot expect competitive advantages from imitating the low-
cost manufacturing strategies of other firms, while firms with cultural
or other advantages in low-cost manufacturing, if few other firms have
these same advantages, can exploit them to obtain such advantages (Ouchi
1981; Peters and Waterman 1982, 2004). Also firms that currently enjoy
competitive advantages may do so because of unique insights and abilities
they controlled when their strategies were chosen. On the other hand, these
firms might also have been lucky. Thus, competitive advantage is not always
a sign of strategizing and managerial excellence (Peters and Waterman
1982, 2004).
This emphasis on the nature of the competition for the resources needed
to implement strategies differs from previous work in the field of strategy.
Much of this research was based on the observation that firms which
compete in imperfectly competitive product markets enjoy competitive
advantages (Porter 1980). As a description of the correlation between
imperfect product market competition and economic rents, this research
has significant theoretical and empirical support (Hirshleifer 1980). Its
implications for managers are less clear. Simply because firms that compete
in imperfectly competitive product markets earn economic rents does not
necessarily imply that firms that adopt strategies to create these product
market imperfections will enjoy such performance. As suggested here, this
will depend on the competitive characteristics of the markets through
which the resources necessary to implement these strategies are developed
or acquired, that is, on the competitive characteristics of strategic factor
markets.
Perhaps the central conclusion of the arguments developed here is that
the search for competitive advantage and superior firm performance must
begin with an analysis of the resources and capabilities a firm currently
48 RESOURCE-BASED THEORY

controls. But of all the assets currently controlled by a firm, which are most
likely to be a source of sustained competitive advantage? This question is
addressed in more detail in Chapter 3.

NOTES

1. As suggested in Barney (1986a), economic rents can also be unexpected. However,


these will be a manifestation of a firm’s good luck rather than its strategic choices.
This possibility is also discussed briefly below.
2. How this total cost is allocated across these different, but interrelated, strategic factor
markets depends on the relative contribution of each of these factors of production
to a firm’s ability to conceive and implement successful product market strategies. See
Coff (1999).
3 Firm resources and
sustained competitive
advantage∗

Chapter 1 of this book defined and developed the strategic management


question—Why do some firms outperform other firms?—and described
the evolution of resource-based theory as one approach to answering this
question. Chapter 2 introduced the concept of a strategic factor market to
demonstrate that whether a firm gains competitive advantages does not
depend just on strategies that create competitive imperfections in prod-
uct markets, but on the total cost of implementing these strategies. This
total cost is determined by the competitiveness of strategic factor markets.
One of the central conclusions of this argument is that firms that exploit
resources and capabilities they already control in choosing and implement-
ing strategies are more likely to gain competitive advantages than firms that
acquire the resources and capabilities they need to implement a strategy in
more competitive factor markets.
Of course, this conclusion is hardly unique to resource-based the-
ory. Indeed, identifying and exploiting a firm’s strengths while avoid-
ing its weaknesses has been one of the central features of one of the
oldest organizing frameworks in the field of strategic management—
the SWOT framework (Ansoff 1965; Andrews 1971; Hofer and Schendel
1978). This framework, summarized in Figure 3.1, suggests that firms
obtain competitive advantages by implementing strategies that exploit
their internal strengths, through responding to environmental opportu-
nities, while neutralizing external threats and avoiding internal weak-
nesses. Most research on sources of competitive advantage has focused
either on isolating a firm’s opportunities and threats (Porter 1980, 1985),
describing its strengths and weaknesses (Penrose 1959; Stinchcombe 1965;
∗ This chapter draws from Barney (1991a).
50 RESOURCE-BASED THEORY

Internal analysis External analysis

Strengths Opportunities

Weaknesses Threats

Resource-based Environmental
model models of competitive
advantage

Figure 3.1. The relationship between traditional ‘SWOT’ analysis, the resource-
based model, and models of industry attractiveness

Hofer and Schendel 1978), or analyzing how these are matched to choose
strategies.
While SWOT analysis does draw attention to the important role of
understanding a firm’s internal capabilities in choosing strategies, it has
at least one important limitation in this regard: there is, in this framework,
no logic provided to identify a firm’s strengths or weaknesses. That is, the
framework suggests that, for example, firms should choose strategies that
exploit their strengths, but no mechanism is described through which these
strengths can be identified.
In practice, applications of SWOT analysis often devolve into generating
lists of ‘things’ a firm is ‘good’ at, together with lists of ‘things’ a firm is ‘not
so good’ at. This can lead to what has sometimes been called ‘decision-
making by list length’—whatever strategic option gets the most strengths
listed for it is the best strategy. Sometimes, the results of this list making
are almost comical. For example, if you ask successful entrepreneurs why
they are successful, they will routinely identify three central strengths—
they worked hard, they took risks, and they surrounded themselves by good
people. Ask failed entrepreneurs what happened, and they will often shrug
their shoulders: ‘I don’t know, I worked hard, took risks, and surrounded
myself by good people.’ You ask CEOs what their firm’s core strengths
are; they almost always identify their top management team. When asked
to evaluate their competition’s top management teams, CEOs instantly
acknowledge, ‘They are really good, too.’
FIRM RESOURCES AND SCA 51

Perhaps the most extreme example of listing as strategic analysis was


shared at a meeting of the Strategic Management Society.1 A consultant
described an unnamed company whose CEO decided that the firm would
only keep any of its diversified operations if those operations ‘contributed
to the core competence of the corporation’. Division managers were given
several months to develop ways that their business units helped define the
‘strengths’ of the corporation. The average division identified over 500 ways
it contributed to the core competence of this corporation!
One way to help resolve this problem might be to turn to the liter-
ature that helps firms identify environmental opportunities and threats.
However, this literature—exemplified in Porter’s five forces framework
(1980)—has implicitly adopted two simplifying assumptions. First, these
environmental tools have assumed that firms within an industry (or firms
within a strategic group) are, except for firm size, essentially the same in
terms of the strategically relevant resources they control and the strategies
they pursue (Scherer 1980; Porter 1981; Rumelt 1984). Second, these mod-
els assume that should resource heterogeneity develop in an industry or
group (perhaps through new entry), this heterogeneity will be very short
lived because the resources that firms use to implement their strategies
are highly mobile (i.e. they can be bought and sold in factor markets, see
Chapter 2).2
The link between a firm’s internal characteristics and performance obvi-
ously cannot build on these same assumptions. These assumptions effec-
tively eliminate firm resource heterogeneity and immobility as possible
sources of competitive advantage (Penrose 1959; Rumelt 1984; Wernerfelt
1984, 1989). Resource-based theory substitutes two alternate assumptions
in analyzing sources of competitive advantage. First, this model assumes
that firms within an industry (or group) may be heterogeneous with
respect to the strategic resources they control. Second, this model assumes
that these resources may not be perfectly mobile across firms, and thus
heterogeneity can be long lasting. The resource-based model of the firm
examines the implications of these two assumptions for the analysis of
sources of sustained competitive advantage.
Of course, not all of a firm’s resources are likely to be economically
valuable. Indeed, some of these firm attributes may actually make it
more difficult for a firm to conceive and implement valuable strategies
(Barney 1986b). Others may have no impact on a firm’s strategizing efforts.
52 RESOURCE-BASED THEORY

However, those attributes of a firm’s physical, financial, human, and orga-


nizational capital that do enable a firm to conceive and implement strate-
gies that improve its efficiency and effectiveness are, for purposes of this
discussion, valuable firm resources (Wernerfelt 1984). The purpose of this
chapter is to specify the conditions under which such firm resources can be
a source of sustained competitive advantage for a firm.

Competitive advantage and sustained


competitive advantage

The concept of competitive advantage was defined in Chapter 1. There, it


was suggested that a firm has a competitive advantage when it is able to
create more economic value than the marginal firm in its industry. How-
ever, as important as it is to explain the existence of competitive advantages
among firms, the sustainability of these advantages is also important. Some
competitive advantages are fleeting, others can be long lasting. In resource-
based logic, a firm is said to have a sustained competitive advantage when
it is creating more economic value than the marginal firm in its industry
and when other firms are unable to duplicate the benefits of this strategy.
A couple of comments about sustained competitive advantage are in order.
First, unlike the concept of competitive advantage, sustained competi-
tive advantage does not focus exclusively on a firm’s competitive position
vis-à-vis firms that are already operating in its industry. Rather, following
Baumol, Panzar, and Willig (1982), a firm’s competition is assumed to
include not only all of its current competitors, but also potential competi-
tors poised to enter an industry at some future date.
Second, the definition of sustained competitive advantage adopted here
does not necessarily depend on the period of calendar time during which
a firm enjoys a competitive advantage. One indicator that a firm may have
a sustained competitive advantage is that it has a competitive advantage
that lasts a long time (Porter 1985; Jacobsen 1988). However, in some
industry settings, a sustained competitive advantage may not last a long
period of calendar time. In such settings, it may be possible for a firm to
have a competitive advantage that lasts for a relatively short period. But if
that advantage is not competed away through other firms duplicating the
FIRM RESOURCES AND SCA 53

strategy of the firm with a competitive advantage, then that advantage may
still have been sustained.
The imperfect link between the calendar time a firm enjoys a competitive
advantage and the concept of a sustained competitive advantage reflects the
fact that the sustainability of a competitive advantage ultimately depends
on what might be called the ‘condition of duplication’. If current and
potential firms are unable to duplicate the competitive advantage of a
successful firm, that firm’s competitive advantage is sustained. In this sense,
the ‘condition of duplication’ is analogous to the ‘condition of entry’ in
many SCP-based models of firm performance (Bain 1968) and, following
Lippman and Rumelt (1982) and Rumelt (1984), the resulting definition
of sustained competitive advantage can be thought of as an equilibrium
definition.
However, that a firm has a sustained competitive advantage does not
mean that its competitive advantage will last forever. Changes in technol-
ogy, demand, and the broader institutional context within which a firm
operates can all make what used to be a source of sustained competitive
advantage no longer valuable.
These kinds of changes have been called ‘Schumpeterian Shocks’ by
several authors (Schumpeter 1934, 1950; Rumelt and Wensley 1981a;
Barney 1986c). Such shocks redefine which of a firm’s resources are valu-
able and which are not. Some of these resources, in turn, may be sources
of sustained competitive advantage in the newly defined industry structure
(Barney 1986c). However, what were resources in a previous industry set-
ting may be weaknesses, or simply irrelevant, in a new industry setting.
A firm enjoying a sustained competitive advantage may experience these
major shifts in the structure of competition and may see its competitive
advantages nullified by such changes. Just as being the world’s best buggy
whip manufacturer is not a source of sustained competitive advantage in
a world dominated by automobiles, so too can political connections that
were a source of sustained competitive advantages in one political regime
no longer be a source of sustained competitive advantage if that regime is
overthrown. In all these cases, however, a sustained competitive advantage
is not lost through the efforts of other firms to duplicate the bases of
these advantages. Rather, this sustained competitive advantage is replaced
when alternative technologies, changes in demand, or other changes take
place.
54 RESOURCE-BASED THEORY

Competition with homogeneous and perfectly


mobile resources

Armed with a definition of sustained competitive advantage, it is now


possible to explore the impact of resource heterogeneity and immobility
on this concept. This is done by first examining the possibility of sustained
competitive advantage when firm resources are perfectly homogeneous and
mobile. Then, the possibility of sustained competitive advantage under
heterogeneity and immobility is examined.
Of course, the analysis of sustained competitive advantage under perfect
firm homogeneity and mobility does not suggest that there are industries
where the attributes of perfect homogeneity and mobility actually exist.
Although this is ultimately an empirical question, it seems reasonable to
expect that most industries will be characterized by at least some degree
of resource heterogeneity and immobility (Barney and Hoskisson 1989).
Thus, rather than making an assertion that firm resources are homoge-
neous and mobile, the purpose of this analysis is to examine the possibility
of discovering sources of sustained competitive advantage under these con-
ditions. Not surprisingly, it is argued that firms, in general, cannot expect to
obtain sustained competitive advantage when strategic resources are evenly
distributed across all competing firms and highly mobile. This conclusion
suggests that the search for sources of sustained competitive advantage
must focus on firm resource heterogeneity and immobility.
Imagine an industry where firms possess exactly the same resources.
This condition suggests that firms all have the same amount and kinds of
strategically relevant physical, financial, human, and organizational capital.
Is there a strategy that could be conceived and implemented by any one
of these firms that could not also be conceived and implemented by all
other firms in this industry? The answer to this question must be no.
The conception and implementation of strategies employs various firm
resources (Wernerfelt 1984; Barney 1986a; Hatten and Hatten 1987). That
one firm in an industry populated by identical firms has the resources to
conceive and implement a strategy means that these other firms, because
they possess the same resources, can also conceive and implement this
strategy. Because these firms all implement the same strategies, they all will
improve their efficiency and effectiveness in the same way and to the same
FIRM RESOURCES AND SCA 55

extent. Thus, in this kind of industry, it is not possible for firms to enjoy a
competitive advantage.
One objection to this conclusion concerns so-called ‘first-mover advan-
tages’ (Lieberman and Montgomery 1988). In some circumstances, the
first firm in an industry to implement a strategy can obtain a sustained
competitive advantage over other firms. These firms may gain access to
distribution channels, develop goodwill with customers, or develop a posi-
tive reputation, all before firms that implement their strategies later. Thus,
first-moving firms may obtain a competitive advantage which might also
be sustained.
However, upon reflection, it seems clear that if competing firms are
identical in the resources they control, it is not possible for any one firm
to obtain a competitive advantage from first moving. To be a first mover
by implementing a strategy before any competing firms, a particular firm
must have insights about the opportunities associated with implementing
a strategy that are not possessed by other firms in the industry, or by poten-
tially entering firms (Lieberman and Montgomery 1988). This unique firm
resource (information about an opportunity) makes it possible for the
better-informed firm to implement its strategy before others. However,
by definition, there are no unique firm resources in this kind of industry.
If one firm in this type of industry is able to conceive and implement a
strategy, then all other firms will also be able to conceive and implement
that strategy, and these strategies will be conceived and implemented in
parallel, as identical firms become aware of the same opportunities and
exploit that opportunity in the same way.
It is not being suggested that there can never be first-mover advantages
in industries. It is being suggested that in order for there to be a first-mover
advantage, firms in an industry must be heterogeneous in terms of the
resources they control.
A second objection to the conclusion that sustained competitive advan-
tages cannot exist when firm resources in an industry are perfectly homo-
geneous and mobile concerns the existence of ‘barriers to entry’ (Bain
1956) or more generally, ‘mobility barriers’ (Caves and Porter 1977). The
argument here is that even if firms within an industry (group) are perfectly
homogeneous, if there are strong entry or mobility barriers, these firms
may be able to obtain a sustained competitive advantage vis-à-vis firms
that are not in their industry (group).
56 RESOURCE-BASED THEORY

However, from another point of view, barriers to entry or mobility are


only possible if current and potentially competing firms are heterogeneous
in terms of the resources they control and if these resources are not per-
fectly mobile (Barney, McWilliams, and Turk 1989). The heterogeneity
requirement is self-evident. For a barrier to entry or mobility to exist, firms
protected by these barriers must be implementing different strategies than
firms seeking to enter these protected areas of competition. Firms restricted
from entry are unable to implement the same strategies as firms within
the industry or group. Because the implementation of strategy requires
the application of firm resources, the inability of firms seeking to enter
an industry or group to implement the same strategies as firms within that
industry or group suggests that firms seeking to enter must not have the
same strategically relevant resources as firms within the industry or group.
Thus, barriers to entry and mobility only exist when competing firms are
heterogeneous in terms of the strategically relevant resources they control.
Indeed, this is the definition of strategic groups suggested by McGee and
Thomas (1986).
The requirement that firm resources be immobile in order for barriers to
entry or mobility to exist is also clear. If firm resources are perfectly mobile,
then any resource that allows some firms to implement a strategy protected
by entry or mobility barriers can easily be acquired by firms seeking to enter
into this industry or group. Once these resources are acquired, the strategy
in question can be conceived and implemented in the same way that other
firms have conceived and implemented their strategies. These strategies are
thus not a source of sustained competitive advantage.
Again, it is not being suggested that entry or mobility barriers do not
exist. However, it is being suggested that these barriers only become sources
of sustained competitive advantage when firm resources are not homoge-
neously distributed across competing firms and when these resources are
not perfectly mobile.
Research that has focused on the impact of opportunities and threats in
a firm’s environment on competitive advantage has recognized the limi-
tations inherent in analyzing competitive advantage with the assumption
that firm resources are homogeneously distributed and highly mobile. In
his work, Porter (1985) introduced the concept of the value chain to assist
managers in isolating potential resource-based advantages for their firms.
The resource-based theory developed here simply pushes this value chain
FIRM RESOURCES AND SCA 57

logic further, by examining the attributes that resources isolated by value


chain analyses must possess in order to be sources of sustained competitive
advantage (Porter 1990).

Firm resources and sustained competitive advantage

Thus far, it has been suggested that in order to understand sources of


sustained competitive advantage, it is necessary to build a theoretical model
that begins with the assumption that firm resources may be heterogeneous
and immobile. Of course, not all firm resources hold the potential of
sustained competitive advantages. To have this potential, a firm resource
must have four attributes: (a) it must be valuable, in the sense that it
exploits opportunities and/or neutralizes threats in a firm’s environment,
(b) it must be rare among a firm’s current and potential competition, (c) it
must be imperfectly imitable, and (d) it must be able to be exploited by
a firm’s organizational processes. These attributes of firm resources can
be thought of as indicators of how heterogeneous and immobile a firm’s
resources are, and thus how useful these resources are for generating sus-
tained competitive advantages. Each of these attributes of a firm’s resources
is discussed in more detail below.

VALUABLE RESOURCES
Firm resources can only be a source of competitive advantage or sus-
tained competitive advantage when they are valuable. As suggested earlier,
resources are valuable when they enable a firm to conceive or implement
strategies that improve its efficiency and effectiveness. The traditional
‘strengths–weaknesses–opportunities–threats’ model of firm performance
suggests that firms are able to improve their performance only when
their strategies exploit opportunities or neutralize threats. Firm attributes
may have the other characteristics that could qualify them as sources
of competitive advantage (e.g. rarity, inimitability, and organizational
abilities/processes), but these attributes only become valuable resources
when they exploit opportunities or neutralize threats in a firm’s environ-
ment.
58 RESOURCE-BASED THEORY

This analysis perfectly correlates with the definition of competitive


advantage presented in Chapter 1. A valuable resource enables a firm to
increase the economic value it creates by increasing the willingness of
customers to pay, decreasing its costs, or both.
That firm attributes must be valuable in order to be considered as pos-
sible sources of sustained competitive advantage points to an important
complementarity between environmental models of competitive advan-
tage and the resource-based model. These environmental models help
isolate those firm attributes that exploit opportunities and/or neutralize
threats. The resource-based model then suggests what additional char-
acteristics these resources must possess if they are to generate sustained
competitive advantage. Note, this means that the value of a firm’s resources
needs to be evaluated within the context of the firm’s strategy and the
specific market environment.

RARE RESOURCES
Valuable firm resources possessed by large numbers of competing or poten-
tially competing firms cannot be sources of either a competitive advan-
tage or a sustained competitive advantage. A firm enjoys a competitive
advantage when it creates more economic value than the marginal firm
in an industry. If a particular valuable firm resource is possessed by large
numbers of firms, then each of these firms has the capability of exploiting
that resource in the same way, thereby implementing a common strategy
that gives no one firm a competitive advantage.
The same analysis applies to bundles of valuable firm resources used to
conceive and implement strategies. Some strategies require a particular
mix of physical, financial, human, and organizational capital resources
for implementation. One firm resource required in the implementation of
almost all strategies is managerial talent (Hambrick 1987). If this particular
bundle of firm resources is not rare, then large numbers of firms will be able
to conceive and implement the strategies in question, and these strategies
will not be a source of competitive advantage, even though the resources in
question may be valuable.
To observe that competitive advantages (sustained or otherwise) only
accrue to firms that have valuable and rare resources is not to dismiss
FIRM RESOURCES AND SCA 59

common (i.e. not rare) firm resources as unimportant. Instead, these


valuable but common firm resources can help ensure a firm’s survival
when they are exploited to create competitive parity in an industry
(Barney 1989). Under conditions of competitive parity, though no one
firm obtains a competitive advantage, firms do increase their probability
of economic survival (Porter 1980; McKelvey 1982).
How rare a valuable firm resource must be in order to have the potential
for generating a competitive advantage is a difficult question. It is not
difficult to see that if a firm’s valuable resources are absolutely unique
among a set of competing and potentially competing firms, those resources
will generate at least a competitive advantage and may have the poten-
tial of generating a sustained competitive advantage. However, it may
be possible for a small number of firms in an industry to possess a
particular valuable resource and still generate a competitive advantage.
In general, as long as the number of firms that possess a particular
valuable resource (or a bundle of valuable resources) is less than the
number of firms needed to generate perfect competition dynamics in
an industry, that resource has the potential of generating a competitive
advantage.

IMPERFECTLY IMITABLE RESOURCES


It is not difficult to see that valuable and rare organizational resources may
be a source of competitive advantage. Indeed, firms with such resources
will often be strategic innovators, for they will be able to conceive and
engage in strategies that other firms could either not conceive, or not
implement, or both, because these other firms lacked the relevant firm
resources. The observation that valuable and rare organizational resources
can be a source of competitive advantage is another way of describing first-
mover advantages accruing to firms with resource advantages.
However, valuable and rare organizational resources can only be sources
of sustained competitive advantage if firms that do not possess these
resources cannot obtain them by direct duplication or substitution. In
language developed in Lippman and Rumelt (1982) and Barney (1986a,
1986b), these firm resources are imperfectly imitable. Why might a com-
peting firm face a cost disadvantage in imitating a firm’s resources?
60 RESOURCE-BASED THEORY

Firm resources can be imperfectly imitable (or costly to imitate) for one
or a combination of three reasons: (a) the ability of a firm to obtain a
resource is dependent on unique historical conditions, (b) the link between
the resources possessed by a firm and a firm’s sustained competitive advan-
tage is causally ambiguous, or (c) the resource generating a firm’s advantage
is socially complex (Dierickx and Cool 1989). Each of these sources of the
imperfect imitability of firm resources is examined below.

Unique historical conditions


Another assumption of most environmental models of firm competitive
advantage, besides resource homogeneity and mobility, is that the perfor-
mance of firms can be understood independent of the particular history
and other idiosyncratic attributes of firms (Scherer 1980; Porter 1981).
These researchers seldom argue that firms do not vary in terms of their
unique histories, but rather that these unique histories are not relevant to
understanding a firm’s performance (Porter 1980).
The resource-based theory of competitive advantage developed here
relaxes this assumption. Indeed, this approach asserts that not only are
firms intrinsically historical and social entities, but that their ability to
acquire and exploit some resources depends on their place in time and
space. Once this particular unique time in history passes, firms that do not
have space- and time-dependent resources cannot obtain them and thus
these resources are imperfectly imitable.
Resource-based theorists are not alone in recognizing the importance
of history as a determinant of firm performance and competitive advan-
tage. Traditional strategy researchers (e.g. Ansoff 1965; Stinchcombe 1965;
Learned et al. 1969) often cited the unique historical circumstances of a
firm’s founding, or the unique circumstances under which a new man-
agement team takes over a firm, as important determinants of a firm’s
long-term performance. In addition, several economists (e.g. David 1985;
Arthur, Ermoliev, and Kaniovsky 1987) have developed models of firm
performance that rely heavily on unique historical events as determi-
nants of subsequent actions. Employing path-dependent models of eco-
nomic performance (Arthur 1983, 1984a, 1984b; Arthur, Ermoliev, and
Kaniovski 1994), these authors suggest that the performance of a firm does
not depend simply on the industry structure within which a firm finds
FIRM RESOURCES AND SCA 61

itself at a particular point in time, but also on the path a firm followed
through history to arrive where it is. If a firm obtains valuable and rare
resources because of its unique path through history, it will be able to
exploit those resources in implementing value-creating strategies that can-
not be duplicated by other firms, for firms without that particular path
through history cannot obtain the resources necessary to implement the
strategy.
The acquisition of all the types of firm resources examined in this
chapter can depend on the unique historical position of a firm. A firm
that locates its facilities on what turns out to be a much more valuable
location than was anticipated when the location was chosen possesses an
imperfectly imitable physical capital resource (Ricardo 1966). A firm with
scientists who are uniquely positioned to create or exploit a significant
scientific breakthrough may obtain an imperfectly imitable resource from
the history-dependent nature of the scientist’s individual human capi-
tal (Winter 1987; Burgelman and Maidique 1988). Finally, a firm with
a unique and valuable organizational culture that emerged in the early
stages of a firm’s history may have an imperfectly imitable advantage over
firms founded in another historical period, where different (and perhaps
less valuable) organizational values and beliefs come to dominate (Zucker
1977; Barney 1986b).
The literature in strategic management is infused with examples of
firms whose unique historical position endowed them with resources
that are not controlled by competing firms and that cannot be imitated
(e.g. Caterpillar—Rukstad and Horn 1989; Lucent Technologies—Kupfer
1997). These examples are the case analyses that have dominated teaching
and research for so long in the field of strategic management (Learned et al.
1969; Miles and Cameron 1982). In addition, the impact of history on firm
performance has been studied systematically (Collins and Porras 1997).
There are at least two ways that unique historical conditions can give a
firm a sustained competitive advantage. First, it may be that a particular
firm is the first in an industry to recognize and exploit an opportunity,
and being first gives the firm a first-mover advantage. Second, when events
early in the evolution of a process have significant effects on subsequent
events, path dependence allows a firm to gain a competitive advantage in
the current period based on the acquisition and development of resources
in earlier periods.
62 RESOURCE-BASED THEORY

Causal ambiguity
Unlike the relationship between a firm’s unique history and the imitability
of its resources, the relationship between the causal ambiguity of a firm’s
resources and imperfect imitability has received systematic attention in
the strategic management and related literatures (Alchian 1950; Mancke
1974; Lippman and Rumelt 1982; Rumelt 1984; Barney 1986b; Reed and
DeFillippi 1990). In this context, causal ambiguity exists when the link
between the resources controlled by a firm and a firm’s sustained competi-
tive advantage is not understood or understood only very imperfectly.
When the link between a firm’s resources and its sustained competitive
advantage is poorly understood, it is difficult for firms that are attempting
to duplicate a successful firm’s strategies through imitation of its resources
to know which resources it should imitate. Imitating firms may be able to
describe some of the resources controlled by a successful firm. However,
under conditions of causal ambiguity, it is not clear that the resources that
can be described are the same resources that generate a sustained competi-
tive advantage, or whether that advantage reflects some other nondescribed
firm resource. As suggested by Demsetz (1973), sometimes it is difficult
to understand why one firm consistently outperforms other firms. Causal
ambiguity is at the heart of this difficulty. In the face of such causal ambi-
guity, imitating firms cannot know the actions they should take in order to
duplicate the strategies of firms with a sustained competitive advantage.
To be a source of sustained competitive advantage, both the firms that
possess resources that generate a competitive advantage and the firms that
do not possess these resources but seek to imitate them, must be faced with
the same level of causal ambiguity (Lippman and Rumelt 1982). If firms
that control these resources have a better understanding of their impact
on competitive advantage than firms without these resources, then firms
without these resources can engage in activities to reduce their knowledge
disadvantage. They can do this, for example, by hiring away well-placed
knowledgeable managers in a firm with a competitive advantage or by
engaging in a careful systematic study of the other firm’s success. Although
acquiring this knowledge may take some time and effort, once knowledge
of the link between a firm’s resources and its ability to implement certain
strategies is diffused throughout competing firms, causal ambiguity no
longer exists and thus cannot be a source of imperfect imitability. In other
FIRM RESOURCES AND SCA 63

words, if a firm with a competitive advantage understands the link between


the resources it controls and its advantages, then other firms can also learn
about that link, acquire the necessary resources (assuming they are not
imperfectly imitable for other reasons), and implement the relevant strate-
gies. In such a setting, a firm’s competitive advantages are not sustained
because they can be duplicated.
On the other hand, when a firm with a competitive advantage does
not understand the source of its competitive advantage any better than
firms without this advantage, that competitive advantage may be sustained
because it is not subject to imitation (Lippman and Rumelt 1982). Ironi-
cally, in order for causal ambiguity to be a source of sustained competitive
advantage, all competing firms must have an imperfect understanding of
the link between the resources controlled by a firm and a firm’s competitive
advantages. If one competing firm understands this link and no others
do, in the long run this information will be diffused through all competi-
tors, thus eliminating causal ambiguity and imperfect imitability based on
causal ambiguity.
At first, it may seem unlikely that a firm with a sustained competitive
advantage will not fully understand the source of that advantage. However,
given the very complex relationship between firm resources and competi-
tive advantage, such an incomplete understanding is not implausible. The
resources controlled by a firm are very complex and interdependent. Often,
they are implicit, taken for granted by managers, rather than being subject
to explicit analysis (Polanyi 1962; Nelson and Winter 1982; Winter 1988).
Numerous resources, taken by themselves or in combination with other
resources, may yield sustained competitive advantage. Although managers
may have numerous hypotheses about which resources generate their
firm’s advantages, it is rarely possible to rigorously test these hypotheses.
As long as numerous plausible explanations of the sources of sustained
competitive advantage exist within a firm, the link between the resources
controlled by a firm and sustained competitive advantage remains some-
what ambiguous, and thus which of a firm’s resources to imitate remains
uncertain.
Three situations in which managers may not fully understand their
sources of competitive advantage include: (a) when the resources and
capabilities are taken-for-granted organizational characteristics or invisible
assets (Itami 1987) such as teamwork among top mangers, organizational
64 RESOURCE-BASED THEORY

culture, relationships with suppliers and customers; (b) when managers


are unable to evaluate which of their resources and capabilities, alone
or in combination, actually create the competitive advantage; and (c)
when the resources and capabilities are complex networks of relationships
between individuals, groups, and technology, identified by Dierickx and
Cool (1989) as interconnectedness of asset stocks and asset mass efficien-
cies. Whenever the sources of competitive advantage are widely diffused
across people, locations, and processes in a firm, those sources of compet-
itive advantage will be difficult to identify and costly to imitate.

Social complexity
A third reason that a firm’s resources may be imperfectly imitable is that
they may be very complex social phenomena, beyond the ability of firms
to systematically manage and influence. When competitive advantages are
based in such complex social phenomena, the ability of other firms to
imitate these resources is significantly constrained.
A wide variety of firm resources may be socially complex. Examples
include the interpersonal relations among managers in a firm (Hambrick
1987), a firm’s culture (Barney 1986b), a firm’s reputation among sup-
pliers (Porter 1980), and customers (Klein, Crawford, and Alchian 1978;
Klein and Lefler 1981). Note that in most of these cases it is possible to
specify how these socially complex resources add value to a firm. Thus,
there is little or no causal ambiguity surrounding the link between these
firm resources and competitive advantage. However, understanding that,
say, an organizational culture with certain attributes or quality relations
among managers can improve a firm’s efficiency and effectiveness does
not necessarily imply that firms without these attributes can engage in
systematic efforts to create them (Barney 1986b; Dierickx and Cool 1989).
Such social engineering may be, for the time being at least, beyond the
capabilities of most firms (Porras and Berg 1978b; Barney 1986b). To the
extent that socially complex firm resources are not subject to such direct
management, these resources are imperfectly imitable.
Note that complex physical technology is not included in this category of
sources of imperfectly imitable resources. In general, physical technology,
whether it takes the form of machine tools or robots in factories (Hayes
and Wheelwright 1984) or complex information management systems
FIRM RESOURCES AND SCA 65

(Howell and Fleishman 1982), is by itself typically imitable. If one firm can
purchase these physical tools of production and thereby implement some
strategies, then other firms should also be able to purchase these physical
tools, and thus such tools should not be a source of sustained competitive
advantage.
On the other hand, the exploitation of physical technology in a firm
often involves the use of socially complex firm resources. Several firms may
all possess the same physical technology, but only one of these firms may
possess the social relations, culture, traditions, etc. to fully exploit this tech-
nology in implementing strategies (Wilkins 1989). If these complex social
resources are not subject to imitation (and assuming they are valuable and
rare and no substitutes exist), these firms may obtain a sustained compet-
itive advantage from exploiting their physical technology more completely
than other firms, even though competing firms do not vary in terms of
the physical technology they possess. These issues are examined further in
Chapter 7.

Substitutability
History, causal ambiguity, and social complexity can all increase the cost
of another firm duplicating the resources of a particular firm. However, if
substitutes for these resources exist, and if these substitutes are themselves
not costly to duplicate, then firms without these resources can imitate their
effects by substituting resources they can duplicate at low cost. Two valu-
able firm resources (or two bundles of firm resources) are substitutes when
they are strategically equivalent, that is, when they each can be exploited
separately to implement the same strategies.
Suppose that one of these valuable firm resources is rare and imperfectly
imitable, but the other is not. Firms with this first resource will be able
to conceive and implement certain strategies. If there were no strategically
equivalent firm resources, these strategies would generate a sustained com-
petitive advantage (because the resources used to conceive and implement
them are valuable, rare, and imperfectly imitable). However, that there are
strategically equivalent resources suggests that other current or potentially
competing firms can implement the same strategies, but in a different way,
using different resources. If these alternative resources are either not rare
or imitable, then numerous firms will be able to conceive and implement
66 RESOURCE-BASED THEORY

the strategies in question and those strategies will not generate a sustained
competitive advantage. This will be the case even though one approach
to implementing these strategies exploits valuable, rare, and imperfectly
imitable firm resources.
Substitutability can take at least two forms. First, though it may not
be possible for a firm to imitate another firm’s resources exactly, it may
be able to substitute a similar resource that enables it to conceive and
implement the same strategies. For example, a firm seeking to duplicate
the competitive advantages of another firm by imitating that other firm’s
high-quality top management team will often be unable to copy that team
exactly (Hambrick 1987). However, it may be possible for this firm to
develop its own unique top management team. Although these two teams
will be different (different people, different operating practices, a different
history, etc.), they may likely be strategically equivalent and thus be substi-
tutes for one another. If different top management teams are strategically
equivalent and if these substitute teams are common or highly imitable,
then a high-quality top management team is not a source of sustained
competitive advantage even though a particular management team of a
particular firm is valuable, rare, and imperfectly imitable.
Second, very different firm resources can also be strategic substitutes. For
example, managers in one firm may have a very clear vision of the future
of their company because of a charismatic leader in their firm (Zucker
1977). Managers in competing firms may also have a very clear vision of the
future of their companies, but this common vision may reflect these firms’
systematic, companywide strategic planning process (Pearce, Freeman, and
Robinson 1987). From the point of view of managers having a clear vision
of the future of their company, the firm resource of a charismatic leader and
the firm resource of a formal planning system may be strategically equiv-
alent and thus substitutes for one another. If large numbers of competing
firms have a formal planning system that generates this common vision (or
if such a formal planning is highly imitable), then firms with such a vision
derived from a charismatic leader will not have a sustained competitive
advantage even though the firm resource of a charismatic leader is probably
rare and imperfectly imitable.
Of course, the strategic substitutability of firm resources is always a
matter of degree. It is the case, however, that substitute firm resources need
not have exactly the same implications for an organization in order for
FIRM RESOURCES AND SCA 67

those resources to be equivalent from the point of view of the strategies


that firms can conceive and implement. If enough firms have these valuable
substitute resources (i.e. they are not rare), or if enough firms can acquire
them (i.e. they are imitable), then none of these firms (including firms
whose resources are being substituted for) can expect to obtain a sustained
competitive advantage.

ORGANIZATION
Valuable, rare, and imitable resources can only be a source of sustained
competitive advantage if the firm is organized to exploit the potential
offered by these resources. Organizational processes provide the fourth
condition necessary for realization of sustainable competitive advantage.
Numerous components of a firm’s organization influence its ability to
exploit the full competitive potential of its resources and capabilities,
including its formal reporting structure, its explicit management control
systems, and its compensation policies. These components are often called
complementary resources and capabilities as they have limited ability to
generate competitive advantage in isolation. However, in combination with
other resources and capabilities they can enable a firm to realize its full
potential for competitive advantage.
For example, much of Caterpillar’s sustained competitive advantage in
the heavy-construction industry can be traced to its becoming the primary
supplier of this equipment to the Allied forces in World War II. However,
if Caterpillar’s management had not taken advantage of this opportunity
by implementing a global formal reporting structure, global inventory and
other control systems, and compensation policies that created incentives
for employees to work around the world, then Caterpillar’s potential for
competitive advantage would not have been fully realized. By themselves,
these attributes of Caterpillar’s organization could not be a source of
competitive advantage—that is, adopting a global organizational form was
relevant for Caterpillar only because it was pursuing a global opportunity.
However, this organization was essential for Caterpillar to realize its full
competitive advantage potential.
In a similar way, much of Wal-Mart’s continuing competitive advantage
in the discount retailing industry can be attributed to its early entry into
68 RESOURCE-BASED THEORY

rural markets in the southern United States. However, to fully exploit this
geographic advantage, Wal-Mart needed to implement appropriate report-
ing structures, control systems, and compensation policies. One compo-
nent of Wal-Mart’s organization—its point-of-purchase inventory control
system—is being imitated by K-Mart, and thus, by itself, is not likely to be a
source of sustained competitive advantage. However, this inventory control
system has enabled Wal-Mart to take full advantage of its rural locations by
decreasing the probability of stock outs in those locations.
Having an appropriate organization in place has enabled Caterpillar
and Wal-Mart to realize the full competitive advantage potential of their
resources and capabilities. Having an inappropriate organization in place
prevented Xerox from taking full advantage of some of its most critical
valuable, rare, and costly to imitate resources and capabilities.
Through the 1960s and early 1970s, Xerox invested in a series of very
innovative technology development research efforts. Xerox managed this
research effort by creating a stand-alone research center in Palo Alto (Palo
Alto Research Center—PARC) and assembling a large group of highly
creative and innovative scientists and engineers to work there. Left to their
own devices, these scientists and engineers at Xerox PARC developed an
amazing array of technological innovations—the personal computer, the
‘mouse’, Windows-type software, the laser printer, the ‘paperless office’,
Ethernet, and so forth. In retrospect, it is clear that the market potential of
these technologies was enormous. Moreover, because they were developed
at Xerox PARC, they were rare. Xerox may have been able to gain some
important first-mover advantages if the organization had been able to
translate these technologies into products, thereby increasing the cost to
other firms of imitating these technologies.
Xerox possessed very valuable, rare, and costly to imitate resources and
capabilities in the technologies developed at Xerox PARC, but did not
have the organization in place to take advantage of these resources. No
structure existed whereby Xerox PARC innovations could become known
to managers at Xerox. Indeed most Xerox managers—even many senior
managers—were unaware of these technological developments through the
mid-1970s. Once they did become aware of them, very few of the technolo-
gies survived Xerox’s highly bureaucratic product development process, a
process where product development projects were divided into hundreds
of minute tasks and progress in each task was reviewed by dozens of
FIRM RESOURCES AND SCA 69

large committees. Even innovations that survived the product development


process were not exploited by Xerox managers because management com-
pensation at Xerox depended exclusively on maximizing current revenue.
Short-term profitability was relatively less important in compensation cal-
culations and the development of markets for future sales and profitability
was essentially irrelevant. Xerox’s formal reporting structure, its explicit
management control systems, and its compensation policies were all incon-
sistent with exploiting the valuable, rare, and costly to imitate resources
developed at Xerox PARC. Not surprisingly, Xerox failed to exploit any of
the potential sources of sustained competitive advantage.3

A framework for resource-based analysis: VRIO

The relationship between resource heterogeneity and immobility; value,


rarity, imitability, and organization; and sustained competitive advantage
is summarized in Figure 3.2. This has been developed into a frame-
work that can be applied in analyzing the potential of a broad range of
firm resources to be sources of sustained competitive advantage. These
analyses not only specify the theoretical conditions under which sus-
tained competitive advantage might exist, they also suggest specific empir-
ical questions that need to be addressed before the relationship between
a particular firm resource and sustained competitive advantage can be
understood.
The VRIO framework expresses the four key parameters for resource-
based analysis as a series of questions about the business activities of the
firm:

Value
Rareness
Firm resource heterogeneity Imperfect imitability
History dependent Sustained competitive advantage
Firm resource immobility Causal ambiguity
Social complexity
Organization

Figure 3.2. The relationship between resource heterogeneity and immobility,


value, rareness, imperfect imitability, and organization, and sustained compet-
itive advantage
70 RESOURCE-BASED THEORY

1. The question of Value: Do a firm’s resources and capabilities enable


the firm to respond to environmental threats or opportunities?
2. The question of Rarity: Is a resource currently controlled by only a
small number of competing firms?
3. The question of Imitability: Do firms without a resource face a cost
disadvantage in obtaining or developing it?
4. The question of Organization: Are a firm’s other policies and proce-
dures organized to support the exploitation of its valuable, rare, and
costly to imitate resources?

Bringing these questions of value, rarity, imitability, and organization


together provides a single framework to understand the return potential
associated with exploiting any of a firm’s resources or capabilities. This
framework is summarized in Table 3.1.
If a resource or capability controlled by a firm is not valuable, then that
resource will not enable a firm to choose or implement strategies that
exploit environmental opportunities or neutralize threats. Organizing to
exploit this resource will increase a firm’s costs or decrease its revenues.
These types of resources are weaknesses. Firms will either have to fix these
weaknesses or avoid using them when choosing and implementing strate-
gies. If firms do exploit these kinds of resources or capabilities, they can
expect to put themselves at a competitive disadvantage compared to firms

Table 3.1. The VRIO framework

Is a resource or capability . . .
Valuable? Rare? Costly Exploited by Competitive Economic
to imitate? organization? implications performance

No — — No Competitive Below normal


↑ disadvantage
Yes No — | Competitive Normal
|
| parity
Yes Yes No | Temporary Above normal
|
| competitive
↓ advantage
Yes Yes Yes Yes Sustained Above normal
competitive
advantage
FIRM RESOURCES AND SCA 71

that either do not possess these nonvaluable resources or do not use them
in conceiving and implementing strategies.
If a resource or capability is valuable but not rare, exploiting this
resource in conceiving and implementing strategies will generate compet-
itive parity. Exploiting these valuable but not rare resources will generally
not create competitive advantages for a firm, but failure to exploit them
can put a firm at a competitive disadvantage. In this sense, valuable-but-
not-rare resources can be thought of as organizational strengths.
If a resource or capability is valuable and rare but not costly to imitate,
exploiting this resource will generate a temporary competitive advantage
for a firm. A firm that exploits this kind of resource is, in an important
sense, gaining a first-mover advantage, because it is the first firm that
is able to exploit a particular resource. However, once competing firms
observe this competitive advantage, they will be able to acquire or develop
the resources needed to implement this strategy through direct duplica-
tion or substitution at no cost disadvantage compared to the first-moving
firm. Over time, any competitive advantage that the first mover obtained
would be competed away as other firms imitate the resources needed to
compete. However, between the time a firm gains a competitive advantage
by exploiting a valuable and rare but imitable resource or capability and
the time that competitive advantage is competed away through imita-
tion, the first-moving firm can earn above-normal economic performance.
Consequently, this type of resource or capability can be thought of as an
organizational strength and distinctive competence.
If a resource or capability is valuable, rare, and costly to imitate, exploit-
ing this resource will generate a sustained competitive advantage. In this
case, competing firms face a significant cost disadvantage in directly dupli-
cating a successful firm’s resources and capabilities and no easy to duplicate
substitutes for these resources exist. As suggested earlier in this chapter,
this disadvantage may reflect the unique history of the successful firm,
causal ambiguity about which resources to imitate, or the socially complex
nature of these resources and capabilities. In any case, attempts to compete
away the advantages of firms that exploit these resources will not generate
competitive advantages for imitating firms. Even if these firms were able to
acquire or develop the resources or capabilities in question, the very high
costs of doing so would put them at a competitive disadvantage compared
72 RESOURCE-BASED THEORY

to the firm that already possessed the valuable, rare, and costly to imi-
tate resources. These kinds of resources and capabilities are organizational
strengths and sustainable distinctive competencies.
The question of organization operates as an adjustment factor in the
VRIO framework. For example, if a firm has a valuable, rare, and costly to
imitate resource and capability but fails to organize itself to take full advan-
tage of this resource, some of its potential competitive advantage could be
lost (as in the Xerox example). Extremely poor organization, in this case,
could actually lead a firm that has the potential for competitive advantage
to obtain only competitive parity or even competitive disadvantages.

Discussion

This VRIO framework suggests the kinds of questions that need to be


addressed in order to understand whether a particular firm resource is a
source of sustained competitive advantage: Is that resource valuable?, Is
it rare?, Is it imperfectly imitable?, and Is the firm organized to exploit
this resource? This framework is applied to understand the competitive
implications of a variety of firm resources—in Part II of this book—and
specific strategies—in Part III of this book. However, before examining
these applications of the theory, it is appropriate to note some of the
broader implications of resource-based logic and the VRIO framework.

SUSTAINED COMPETITIVE ADVANTAGE AND SOCIAL WELFARE


The resource-based model presented here addresses important social wel-
fare issues linked with strategic management research. Most authors agree
that the original purpose of the structure-conduct-performance paradigm
in industrial organization economics was to isolate violations of the per-
fectly competitive model and to address these violations in order to restore
the social welfare benefits of perfectly competitive industries (Porter 1981;
Barney 1986c). As applied by strategy theorists focusing on environmental
determinants of firm performance, social welfare concerns were aban-
doned in favor of the creation of imperfectly competitive industries within
FIRM RESOURCES AND SCA 73

which a particular firm could gain a competitive advantage (Porter 1980).


At best, this approach to strategic analysis ignores social welfare concerns.
At worst, this approach focuses on activities that firms can engage in that
will almost certainly reduce social welfare.
The resource-based model developed here suggests that, in fact, strategic
management research can be perfectly consistent with traditional social
welfare concerns of economists. Beginning with the assumptions that firm
resources are heterogeneous and immobile, it follows that a firm that
exploits its resource advantages is simply behaving in an efficient and effec-
tive manner (Demsetz 1973). To fail to exploit these resource advantages is
inefficient and does not maximize social welfare. In this sense, the higher
levels of performance that accrue to a firm with resource advantages are
due to the efficiency of these firms in exploiting those advantages, rather
than to the efforts of firms to create imperfectly competitive conditions in
a way that fails to maximize social welfare. These profits, in a sense, can be
thought of as ‘efficiency rents’ (Demsetz 1973) as opposed to ‘monopoly
rents’ (Scherer 1980).

SUSTAINED COMPETITIVE ADVANTAGE AND ORGANIZATION


THEORY AND BEHAVIOR
A variety of authors have suggested that economic models of organi-
zational phenomena fundamentally contradict models of organizations
based in organization theory or organizational behavior (Perrow 1986;
Donaldson 1990a, 1990b). This assertion is fundamentally contradicted
by the resource-based model of sustained competitive advantage (Barney
1990). This model suggests that sources of sustained competitive advan-
tage are firm resources that are valuable, rare, imperfectly imitable, and
exploited by the organization. These resources include a broad range of
organizational, social, and individual phenomena within firms that are the
subject of a great deal of research in organization theory and organiza-
tional behavior (Daft 1983). Rather than being contradictory, the resource-
based model of strategic management suggests that organization theory
and organizational behavior may be a rich source of findings and theories
concerning rare, nonimitable, and exploitable resources in firms. Indeed,
74 RESOURCE-BASED THEORY

a resource-based model of sustained competitive advantage anticipates a


more intimate integration of the organizational and the economic factors
as a way to study sustained competitive advantage.

FIRM ENDOWMENTS AND SUSTAINED COMPETITIVE ADVANTAGE


Finally, the model presented here emphasizes the importance of what
might be called firm resource endowments in creating sustained competi-
tive advantages. Implicit in this model is the assumption that managers are
limited in their ability to manipulate all the attributes and characteristics
of their firms (Barney and Tyler 1991). It is this limitation that makes
some firm resources imperfectly imitable, and thus potentially sources of
sustained competitive advantage. Thus, the study of sustained competitive
advantage depends, in a critical way, on the resource endowments con-
trolled by a firm.
That the study of sources of sustained competitive advantage focuses
on valuable, rare, imperfectly imitable, and exploitable resource endow-
ments does not suggest—as some population ecologists would have it (e.g.
Hannan and Freeman 1977)—that managers are irrelevant in the study
of such advantages. In fact, managers are important in this model, for
it is managers that are able to understand and describe the economic
performance potential of a firm’s endowments. Without such managerial
analyses, sustained competitive advantage is not likely. This is the case even
though the skills needed to describe the rare, imperfectly imitable, and
exploitable resources of a firm may themselves not be rare, imperfectly
imitable, or exploitable.
Indeed, it may be the case that a manager or a managerial team is a
firm resource that has the potential for generating sustained competitive
advantages. The conditions under which this will be the case can be out-
lined using the VRIO framework. However, in the end, what becomes
clear is that firms cannot expect to ‘purchase’ sustained competitive advan-
tages on open markets (Barney 1986a, 1988; Wernerfelt 1989). Rather,
such advantages must be found in the rare, imperfectly imitable, and
exploitable resources already controlled by a firm (Dierickx and Cool
1989).
FIRM RESOURCES AND SCA 75

NOTES

1. This meeting was held in 1995 in Mexico City. The substance of this story comes from
personal communication.
2. Thus, e.g. Porter (1980) suggests that firms should analyze their competitive
environment, choose their strategies, and then acquire the resources needed to
implement their strategies. Firms are assumed to have the same resources to imple-
ment these strategies or to have the same access to these resources. More recently,
Porter (1985) has introduced a language for discussing possible internal organiza-
tional attributes that may affect competitive advantage. The relationship between this
‘value chain’ logic and the resource-based theory of the firm is examined below.
3. See Kearns, D. T. and Nadler, D. A. (1992). Prophets in the Dark. New York: Harper-
Collins; and Smith, D. K. and Alexander, R. C. (1988). Fumbling the Future. New York:
William Morrow.
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Part II
RBT and Organizational
Capabilities
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4 Culture as a source of
sustained competitive
advantage∗

Many attempts to explain the sustained superior financial performance of


firms like Dell, McDonald’s, and Southwest Airlines have focused on the
managerial values and beliefs embodied in these firms’ organizational cul-
tures (Corporate Culture 1980; Deal and Kennedy 1982; Peters and Water-
man 1982; Tichy 1983; Kotter and Heskett 1992; Quick 1992; Freiberg and
Freiberg 1996; Collins and Porras 1997). These explanations suggest that
firms with sustained competitive advantages typically are characterized by
a strong set of core managerial values that define the ways they conduct
business. It is these core values (about how to treat employees, customers,
suppliers, and others) that foster innovativeness and flexibility in firms;
when they are linked with management control, they are thought to lead
to sustained competitive advantage.
Many of these explanations have a strong normative orientation. Firms
with strong cultures are pointed out as examples of excellent management
(Peters and Waterman 1982); mechanisms for modifying the cultures of
other firms to approximate closely the cultures of successful firms have
been widely discussed and applied (Corporate Culture 1980; Quinn 1980;
Tichy 1983). These efforts are seen not only as ways of improving employee
morale or quality of work life, but also as vital for improving a firm’s
performance. Recall that Peters and Waterman (1982) and Collins and
Porras (1997) chose firms for their samples that not only had an excellent
reputation for management, but also were superior financial performers
over long periods.
This chapter examines the relationship between organizational culture
and sustained competitive advantage. The conditions under which a firm’s
∗ This chapter draws from Barney (1986b).
80 RBT AND ORGANIZATIONAL CAPABILITIES

culture can be a source of sustained competitive advantage. It is concluded


that, under a relatively narrow set of conditions, a firm’s culture can
be the source of such sustained advantages. However, arguments suggest
that the normative implications of studies on organizational cultures are
limited significantly. While some firms may obtain sustained competitive
advantages from their organizational cultures, firms without such cul-
tures cannot expect to engage in managerial activities that will develop
cultures that, in turn, will generate such activities. Thus, the normative
implications of studies on organizational cultures are limited to describ-
ing how firms enjoying sustained competitive advantages can maintain
their success, and how less successful firms can obtain competitive parity.
Studies of cultures cannot be used to describe how less successful firms,
by modifying their cultures, can come to enjoy sustained competitive
advantages.
First, some of the key concepts used in this analysis are defined. Second,
the attributes that a firm’s culture must have in order to be a source of
sustained competitive advantage are discussed. Third, the organizational
cultures of at least some firms are examined to see if they meet these
criteria. Finally, whether firms that do not currently have organizational
cultures that are a source of advantage can engage in managerial actions to
develop such cultures is considered.

Defining culture and competitive advantage

Few concepts in organizational theory have as many different and compet-


ing definitions as ‘organizational culture’. Smircich (1983), for example,
has cited five classes of such definitions in her literature review. Rather
than attempt to resolve these numerous and subtle definitional conflicts, a
definition that is consistent with most of the research about organizational
culture and a firm’s performance is used here (e.g. Deal and Kennedy 1982;
Peters and Waterman 1982). In this work, organizational culture typically
is defined as a complex set of values, beliefs, assumptions, and symbols
that define the way in which a firm conducts its business. In this sense,
culture has pervasive effects on a firm because a firm’s culture not only
defines who its relevant employees, customers, suppliers, and competitors
are, but it also defines how a firm will interact with these key actors
CULTURE 81

(Louis 1983; Schein 1999). This conception of organizational culture blurs


classical distinctions between an organization’s culture and its structure
and strategy (Tichy 1983) because these attributes of a firm are direct
manifestations of cultural assumptions about what business a firm is in
and how it conducts that business.
While it is difficult to identify a single definition of organizational cul-
ture that incorporates all the facets of this concept, the dependent variable
in this analysis—sustained competitive advantage—is defined as described
in Chapters 1 and 3. A firm has a competitive advantage when it is cre-
ating more economic value than the marginal firm in its industry; it has
a sustained competitive advantage when efforts to duplicate the bases of
that advantage have ended. Sustained competitive advantages tend to last
longer than other kinds of competitive advantages.

Culture and sustained superior financial performance

In order for a firm’s culture to provide sustained competitive advantages,


three conditions must be met (Barney 1991a). First, the culture must be
valuable; it must enable a firm to do things and behave in ways that lead to
high sales, low costs, high margins, or in other ways create economic value
to the firm. Because sustained competitive advantage is an economic con-
cept, culture, to generate such performance, must have positive economic
consequences. Second, the culture must be rare; it must have attributes
and characteristics that are not common to the cultures of a large number
of other firms. Finally, such a culture must be imperfectly imitable; firms
without these cultures cannot engage in activities that will change their
cultures to include the required characteristics, and if they try to imitate
these cultures, they will be at some disadvantage (reputational, experience,
etc.) compared to the firm they are trying to imitate.
These three characteristics are all derived from the VRIO framework
presented in Chapter 3. The first requirement that a firm’s culture must
enable it to do things and behave in ways that add economic value to the
firm is clearly a prerequisite for generating even competitive parity. If a
firm’s culture enables it to behave in ways that are inconsistent with a firm’s
competitive situation, then that culture cannot be a source of superior
performance, sustained, or otherwise.
82 RBT AND ORGANIZATIONAL CAPABILITIES

The requirement that valuable cultures must be rare to generate sus-


tained competitive advantages reflects the dynamics of competition created
by a competitive advantage. If many firms have similar cultures that allow
them to behave and compete in approximately the same way, then none
will possess a culturally based competitive advantage.
Finally, even if the above conditions are met, it is still necessary for
a firm’s culture to be imperfectly imitable for it to generate sustained
superior financial performance. Perfectly imitable cultures, even if they
are valuable, and even if they are currently rare, are subject to imitation
that dissipates any competitive advantages they may provide. The culture-
driven success of one firm creates an incentive for other firms to modify
their cultures to duplicate that success. If the culture is perfectly imitable,
it cannot give any one firm a sustained competitive advantage. Thus, for
example, if the cultural attributes isolated by Peters and Waterman (1982)
are, in fact, easily transferable, as is suggested on the cover of one of the
paperback editions of their book, then these cultural attributes cannot be
a source of sustained competitive advantage.
A firm that has a valuable, rare, and imperfectly imitable culture enjoys
a sustained competitive advantage that reflects that culture. Such a firm
will enjoy the positive economic consequences of its culture. Relatively few
other firms will be able to obtain these same benefits, and those firms that
currently do not enjoy them cannot engage in activities that will make it
possible to obtain them. However, the overall performance of a firm with
such advantages can be reduced if a firm fails to manage other strategically
relevant functions successfully (Peters and Waterman 1982). These other
functions might include both the financial and analytical characteristics of
a firm’s business. In addition, while a firm with a valuable, rare, and imper-
fectly imitable culture can obtain sustained advantages, other attributes of
a firm, including, perhaps, unique geographic advantages and luck, also
can lead to such performance (Barney 1985b).
This analysis does not imply that firms currently enjoying culturally
based advantages will always enjoy these advantages, because a valuable
culture today could, in different economic or competitive conditions,
become an economic liability. Moreover, because other attributes of a firm
also can generate sustained advantages, it is possible that several firms in an
industry all can obtain sustained superior financial performance based on
different competitive advantages (Lippman and Rumelt 1982). However, it
CULTURE 83

will not be possible for a large number of firms to obtain such performance
on the basis of a single type of organizational culture.

Competitive advantage from organizational culture

If a firm’s culture, in order to be the source of sustained competitive advan-


tages, must be valuable, rare, and imperfectly imitable, then the possibility
that organizational cultures with these characteristics exist must be eval-
uated. Previous research on organizational cultures suggests that at least
some cultures of some firms have these characteristics, and thus can be a
source of sustained competitive advantage. This research also suggests that
not all firms have cultures with these three attributes (Martin et al. 1983;
Tichy 1983), and thus organizational culture is not a source of competitive
advantage for all firms.

THE ECONOMIC VALUE OF CULTURE


Much of the literature on organizational culture and the performance
of a firm can be interpreted as suggesting that culture can have signifi-
cant positive economic value for a firm. Certain organizational cultures
apparently enable firms to do and be things for employees, customers,
suppliers, and others that could not be done, or could not be done as
well, by firms without these cultures (Ouchi 1981; Deal and Kennedy
1982). Many of these activities have shown a positive economic impact on
firms.
Peters and Waterman (1982) provided a broad description of the eco-
nomic value of certain organizational cultures. Each of their eight char-
acteristics of an excellent company reflects strong values and beliefs in
organizational cultures. Thus, for example, firms that are simultaneously
loosely and tightly coupled typically have an organizational culture with
a strong set of core values—one of which encourages creativity and inno-
vativeness (Peters and Waterman 1982: 319). Firms without such a cul-
ture may attempt to develop the attributes of a tight–loose system, but
such attempts generally are not as successful because the culture of the
organization neither supports nor values such behavior. In a similar vein,
84 RBT AND ORGANIZATIONAL CAPABILITIES

firms that are successful at obtaining productivity through their people


generally have an organizational culture that supports and values the worth
of the employee. Firms without such a supportive culture generally do not
succeed in maximizing their productivity through their people. Firms that
stay close to their customers typically are obsessed with customer service
and satisfaction. This obsession, once again, reflects some of the core values
of an organization’s culture.
Each of these cultural traits can result in positive economic gains for
firms. Both Peters and Waterman (1982) and Porter (1980) note that stay-
ing close to one’s customer can result in timely market information, joint
product development activities, and intense brand loyalties. These benefits
result in high sales and increased margins, and thus have a direct positive
financial impact on a firm. Innovativeness, productivity through people,
and the other cultural factors cited by Peters and Waterman (1982) also
have positive economic consequences.
Simply because the cultures of certain firms enable them to engage in
activities with positive economic impact does not imply that all organiza-
tional cultures have such effects. Indeed, implicit in much of the organi-
zation cultures literature is the notion that an organization’s culture can
significantly reduce a firm’s effectiveness, disabling the firm from perceiv-
ing all its competitive/operational options and preventing it from choosing
options consistent with competitive/operational necessities (Crozier 1964;
Porter 1980; Riley 1983; Tichy 1983).

VALUABLE AND RARE CULTURES


That a firm’s culture may enable it to behave in ways with positive eco-
nomic impact does not necessarily imply that a firm can obtain sus-
tained competitive advantages from its culture. In addition, these cultural
attributes must be rare.
The frequency with which valuable organizational cultures occur among
firms is ultimately an empirical question. Previous research has indicated
that some organizational cultures, far from being rare, are likely to be
quite common among any given set of firms (DiMaggio and Powell 1983;
Spender 1983). Indeed, some have argued that though cultures may appear
to be unique or specific to a given firm, they sometimes actually reflect an
CULTURE 85

underlying commonality and function, and thus are not rare at all (Martin
et al. 1983).
Despite these findings, it must be admitted that some organizational
cultures might exist in a relatively small number of firms, and thus hold
the potential for generating sustained superior financial performance.
Numerous authors have noted that firms are idiosyncratic social inven-
tions, reflecting the unique personalities and experiences of those who
work there (Polanyi 1958; Barley 1983). Firms are also historically bound,
partially reflecting the unique circumstances of their founding (Selznick
1957; Pettigrew 1979), the unique personalities of their founders (Zucker
1977; Schein 1983), and the unique circumstances of their growth
(Chamberlin 1933; Clark 1970, 1972). Often, these unique experiences of
a firm are reflected in a firm’s culture. Rare experiences can lead to a rare
culture. If these cultures are also valuable, then they hold the potential for
generating sustained competitive advantages.
The assertion that the unique personalities and history of a firm can
lead to rare cultures is consistent with the contingency view of culture
discussed by Smircich (1983). However, this does not necessarily imply
that the cultures of these firms will be unique as well (Martin et al. 1983).
Different organizational experiences may lead to similar cultural outcomes.
Even among firms with unique histories, cultures may not be rare, and thus
without potential for generating sustained superior financial performance.

THE IMITABILITY OF CULTURE


For a firm’s culture to be a source of sustained competitive advantage, it
must not only be valuable and rare, it also must be imperfectly imitable.
Without imperfect imitability, any competitive advantage that a valuable
and rare culture might give will create strong incentives for imitation.
There is significant evidence which suggests that valuable and rare orga-
nizational cultures often may be very difficult, if not impossible, to imi-
tate. First, it may not be possible for individuals observing a culture (let
alone those experiencing a culture) to describe what about a particular
organization’s culture adds value to a firm (Lippman and Rumelt 1982).
Values, symbols, beliefs, and the like are notoriously difficult to describe
and categorize (Barley 1983; Gregory 1983). Moreover, the relationship
86 RBT AND ORGANIZATIONAL CAPABILITIES

between these highly subjective organizational characteristics and a firm’s


competitive advantages also defies rigorous description and inspection.
The valuable and rare aspects of an organization’s culture often become
part of the unspoken, unperceived common sense of the firm. Many have
argued that culture is a powerful force in explaining the behavior of
individuals and groups within organizations precisely because it is unspo-
ken and taken for granted (Polanyi 1958; Goffman 1959; Berger and Luck-
man 1967). If those attempting to observe a culture to imitate it cannot
describe what it is about it that is valuable, those aspects of that culture
cannot be consciously imitated—though firms might accidentally success-
fully imitate a culture they cannot describe (Lippman and Rumelt 1982;
McKelvey 1982).
Even if valuable and rare organizational cultures can be described by
potential imitators, as is apparently sometimes possible (e.g. Ouchi 1981;
Peters and Waterman 1982), it still may not be possible to imitate these
cultures. The characteristics of organizational culture may make it rare
and may also make it difficult to imitate. Valuable organizational cultures
may be intrinsically bound up with a firm’s unique history and heritage—
and history defies easy imitation. This conception of culture is explored in
Clark’s notion (1970, 1972) of an organizational saga, that is, the embodi-
ment of the values, symbols, and beliefs of a firm as expressed through its
unique history. Selznick (1957), Stinchcombe (1965), and Zucker (1977)
observed that the constellation of persistent symbols, beliefs, and values
that characterize a firm’s culture at least partially reflects the unique early
history of the firm, including the pattern-setting influence of company
founders. A firm with a history significantly different from that of a firm
whose culture it would like to imitate may find an unbridgeable barrier to
imitation. If this firm’s culture is also valuable and rare, then it may enjoy
a sustainable competitive advantage.
Finally, even if the economically relevant aspects of a firm’s culture can
be described, and even if they are not historically specific in character, con-
scious and successful cultural imitation may still be imperfect. The com-
ponents of organizational culture (including values, symbols, and beliefs)
are as difficult to purposefully change as they are to describe (Smircich
1983). The existence of multiple, possibly contradictory cultures within
the same firm makes the management of culture all the more problem-
atic (Gregory 1983). Indeed, the data show that attempts to modify such
CULTURE 87

subtle and interdependent aspects of organizations through organizational


development methods have met with mixed results at best (Porras and Berg
1978a, 1978b). While numerous authors have described ways in which an
organization’s culture can be managed (Peters 1978; Quinn 1980; Tichy
1983; Schein 1999; Cameron and Quinn 1999), it must be admitted that
at least some organizational cultures resist planned change. If a potential
imitator cannot manage the change of its own culture to approximate the
culture of a firm with a culturally based strategic advantage, then the latter
may be safe from imitation and its strategic advantage may be sustained.
It has been argued that the cultures of some firms may be immune
from planned imitation. If these cultures are valuable and rare, then they
can be a source of sustained competitive advantage. This is not to suggest
that a firm’s culture stays the same since it certainly does evolve over time
(Selznick 1957; Zucker 1977). This also does not suggest that all attributes
of all organizational cultures are imperfectly imitable. Rather, previous
findings indicate that some organizational cultures may be valuable, rare,
and imperfectly imitable, and thus the source of sustained competitive
advantage.

Normative implications of culture research

These arguments have a variety of normative implications, both for man-


agers in firms without valuable cultures and for managers in firms with
valuable cultures.

FIRMS WITHOUT VALUABLE CULTURES


For firms without valuable cultures, the normative implications of these
analyses are somewhat limiting. Such firms cannot expect to obtain even
temporary competitive advantages on the basis of their organizational
culture. However, because a firm’s culture can have such a significant
impact on the ways a firm conducts its business, these firms are often
forced to engage in activities that modify their culture to include at least
some economically valuable attributes. Thus, a firm facing a competitive
environment that requires low-cost production strategies with a culture
88 RBT AND ORGANIZATIONAL CAPABILITIES

that does not emphasize managerial efficiency often will engage in actions
to try to develop the value of efficiency among its managers.
Suppose, through significant managerial efforts expended over time, a
firm is able to modify its culture. Could this modified culture, then, be a
source of sustained competitive advantage? Given our previous analysis,
this seems unlikely for at least two reasons. First, if this firm is imitating
the valuable culture of a competing firm, then even if this firm is successful
at modifying its culture, that modified culture will only enable it to do the
things that the firm it is imitating already does. Such successful imitation
does not give a firm a competitive advantage, sustained or otherwise, in the
area of organizational culture. Rather, it suggests that the valuable culture
in question is less rare than it was before imitation, which in turn implies
the likely development of reduced margins due to competitive entry. Thus,
the best return that a firm can expect from imitating the valuable culture
of a competing firm is competitive parity.
The second reason is that if one firm can consciously manage its culture
to modify it to enhance its value, then other firms also are likely to modify
their cultures in this manner. Returns to culture modifications depend not
only on improving the economic value of a firm’s culture, but also on the
ability of other firms to make modifications in their cultures that result in
similar cultures. If a large number of firms can successfully manage this
change, then these culture changes will not result in any one firm enjoying
a culture-based competitive advantage. But if only a few firms are able to
modify their cultures appropriately, then these firms can enjoy a sustained
competitive advantage.
There are at least two reasons why modifying a firm’s culture in this
manner might be possible for only a small number of firms. On the one
hand, firms that are able to successfully modify the economic value of
their cultures may enjoy a superior understanding of the skills necessary
to accomplish this change. That is, they may have superior culture man-
agement skills. Such skills, if they are understood by only a few firms
(i.e. if they are rare) and if those firms that do not have these skills can-
not obtain them (i.e. if they are imperfectly imitable), can enable some
firms to make culture changes while other firms cannot. On the other
hand, some organizational cultures may be more susceptible to change
than others. Young and small firms, for example, often have more flexible
organizational cultures than older and larger firms (Tichy 1983). If these
CULTURE 89

changeable cultures are characteristic of only a small number of competing


firms (i.e. rare), and if firms without changeable cultures cannot develop
change-facilitating attributes (i.e. these changeable cultures are imperfectly
imitable), then firms with these types of cultures can obtain sustainable
advantages. However, if a large number of competing firms have equally
flexible cultures, or if firms without such cultures can engage in activities to
increase the changeability of their cultures, then these cultural traits cannot
be a source of sustained competitive advantage.
There is a paradox central to this discussion. For an organization’s
culture to be the source of sustained competitive advantage, it must be
valuable, rare, and imperfectly imitable. To obtain sustained advantages
from modifying its culture, a firm must have either valuable, rare, and
imperfectly imitable culture management skills or it must have a valuable,
that is, flexible, rare, and imperfectly imitable culture. Firms either have
these attributes, in which case they endow a firm with at least the potential
of sustained advantages, or they do not have them. If they do not have
these attributes, but are successful in acquiring them, then these attributes
are not imperfectly imitable, and thus cannot be the source of sustained
competitive advantages. If it was possible to tell a large number of firms
how to modify their cultures to include economically valuable attributes,
then culture would cease to give any one firm a competitive advantage.
Thus, the normative implications of culture research are limited to assisting
firms that already possess valuable, rare, and imperfectly imitable cultures
and culture management skills in recognizing and nurturing these orga-
nizational characteristics to obtain sustained advantages. Such research,
and the consulting it implies, cannot be used to help firms without valu-
able, rare, or imperfectly imitable cultures or culture management skills to
obtain such performance, for such efforts are, in principle, imitable.

FIRMS WITH VALUABLE CULTURES


From this brief review of findings on organizational culture, it is possible
to conclude that at least some firms have valuable, rare, and imperfectly
imitable cultures. For such firms, the normative implications of these
arguments are clear. These firms should attempt to understand what it
is about their cultures that gives them competitive advantages, and then
90 RBT AND ORGANIZATIONAL CAPABILITIES

to nurture and develop these cultural attributes, thereby increasing the


likelihood that their competitive advantage will not be dissipated through
mismanagement (Stevenson 1976; Lenz 1980).
From another point of view, the injunction that firms should study their
culture to nurture its strengths is a reaffirmation of the now popular notion
that firms should ‘stick to their knitting’ (Peters and Waterman 1982). The
analysis suggests that this recommendation only applies to those firms that
have valuable, rare, and imperfectly imitable cultures. For firms without
valuable cultures, sticking to what they know best cannot generate even
competitive parity. Such activities will jeopardize a firm’s survival in the
long run. Even if firms have valuable cultures, if those cultures are not
rare or imperfectly imitable, they cannot be expected to lead to sustained
competitive advantages. Only if a firm’s culture is valuable, rare, and imper-
fectly imitable will ‘sticking to one’s knitting’ generate sustained superior
financial performance.

Conclusion

A firm’s culture can be a source of sustained competitive advantage if that


culture is valuable, rare, and imperfectly imitable. The sustained superior
performance of firms like Dell, IBM, McDonald’s, and Southwest Air-
lines may be, at least partly, a reflection of their organizational cultures
(Peters and Waterman 1982; Quick 1992). Firms with valuable, rare, and
imperfectly imitable cultures should nurture these cultures. Firms without
valuable, rare, or imperfectly imitable cultures cannot expect their cultures
to be the source of sustained competitive advantages. Nor can such firms
expect that efforts to change their cultures, although they may successfully
incorporate new valuable attributes, will generate sustained superior per-
formance. Such efforts are typically imitable, and thus, at best, only the
source of temporary competitive advantages. These firms must look else-
where if they are to find ways to generate expected sustained competitive
advantages.
The analysis presented here has important implications for debates con-
cerning the ability to manage a firm’s culture to improve financial perfor-
mance (Smircich 1983; Tichy 1983). This reasoning suggests that if firms
can modify their cultures to improve their financial performance, then
CULTURE 91

such modifications can, in the long run, only generate competitive parity.
For if one firm is able to modify its culture, then it is likely that others can
as well. In this case, the advantages associated with this culture are imitable,
and thus only a source of competitive parity. Only when it is not possible
to manage a firm’s culture in a planned way does that culture have the
potential of generating expected sustained advantages. Thus, those who
argue that culture is simply another in a series of manipulatable tools avail-
able to managers for the implementation of business strategies (Schwartz
and Davis 1981; Tichy 1983) deny the possibility that culture can be a
source of sustained advantage, while those who argue that culture is not
readily manipulatable (Smircich 1983) uphold the possibility that culture
can be a source of such sustained advantages.
A firm’s culture is one of several attributes that differentiate firms one
from another (Alchian 1950; Alchian and Demsetz 1972). It is in these
sustainable differences between firms that explanations of sustained com-
petitive advantage must be sought (Demsetz 1973: 2). It is often not easy
to describe what it is about some firms that makes them more successful
than others. Precisely because an organization’s culture is hard to describe,
socially complex and causally ambiguous; because the common sense
of managers is taken for granted; and because even if a culture can be
described, it is difficult to change; a firm’s culture can hold promise for
sustained competitive advantages for some firms.
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5 Trust as a source
of sustained
competitive
advantage∗

Significant differences in assumption and method exist between behav-


iorally oriented and economically oriented organizational scholars (Barney
1990; Donaldson 1990). While these differences manifest themselves in a
wide variety of research contexts, nowhere are they more obvious than in
research on the role of trust in economic exchanges.
On the one hand, behaviorally oriented researchers often criticize eco-
nomic models that assume exchange partners are inherently untrustworthy
(Mahoney, Huff, and Huff 1993) and constantly tempted to behave in
opportunistic ways (Donaldson 1990). These scholars are dissatisfied with
economic analyses that suggest trust will only emerge in an exchange when
parties to that exchange erect legal and contractual protections (called
governance mechanisms) which make it in their self-interest to behave
in a trustworthy manner (Williamson 1975). This rational, calculative,
economic approach to trust, many behavioral scholars argue, is empirically
incorrect (since most exchange partners are, in fact, trustworthy), socially
inefficient (since it leads to an overinvestment in unnecessary governance),
and morally bankrupt (Etzioni 1988). A more reasonable approach, it
is argued, would adopt the assumption that most exchange partners are
trustworthy, that they behave as stewards over the resources they have
under their control (Donaldson and Davis 1991), and thus that trust in
exchange relationships—even without legal and contractual governance
protections—will be common.

∗ This chapter draws from Barney and Hansen (1994).


94 RBT AND ORGANIZATIONAL CAPABILITIES

On the other hand, more economically oriented scholars respond by


observing that, at the very least, it is difficult to distinguish between
exchange partners that are actually trustworthy and those that only claim
to be trustworthy (Arrow 1974, 1985; Williamson 1985). Since one cannot
reliably distinguish between these types of exchange partners, legal and
contractual protections are a rational and effective means of assuring effi-
cient exchange. Trust, many economists would argue, is in fact common in
exchange relationships, precisely because of the constant threat of oppor-
tunistic behavior, linked with governance (Hill 1990). Behavioral assertions
that most exchange partners are inherently trustworthy and that legal or
contractual governance is thus unnecessary, are at best naive, and at worst,
foolish.
These debates about the role of trust in exchange relationships are
interesting, in their own right, but they are not terribly relevant for
strategic management research. Much of this research focuses on under-
standing sources of competitive advantage for firms (Bowman 1974;
Rumelt, Schendel, and Teece 1991). The effort to understand sources
of competitive advantage leads strategy researchers to study differences
between firms that enable some firms to conceive of and implement
valuable strategies that other firms either cannot conceive of or cannot
implement (Barney 1991b). Debates between behavioral and economi-
cally oriented researchers about how trustworthy individuals or firms are
fail to point to these kinds of differences. Moreover, while the behav-
ioral and economic approaches suggest very different processes through
which trust emerges in economic exchanges, both these approaches assert
that trust in economic exchanges will be very common. Such common
attributes of exchange relationships cannot be sources of competitive
advantage for individual firms (Barney 1991b). To be a source of com-
petitive advantage, trust must be available to only a few firms in their
exchange relationships, not to most firms in most exchange relationships
(Peteraf 1993).
The purpose of this chapter is to understand the conditions under
which trust and trustworthiness in exchange relationships can, in fact,
be a source of competitive advantage for firms. First, trust, trustworthi-
ness, and the closely related concept of opportunism are defined. Next
three types of trust in exchange relationships are described: weak form
trust, semi-strong form trust, and strong form trust.1 Then, the conditions
TRUST 95

under which these different types of trust will, and will not, be sources
of competitive advantage for firms are discussed. This chapter concludes
by discussing some of the empirical and theoretical implications of the
analysis.

Defining trust and trustworthiness

Numerous definitions of trust and trustworthiness have been presented


in the literature (Gambetta 1988; Bradach and Eccles 1989; Lewicki and
Bunker 1994). For purposes of this chapter, Sabel’s definition of trust
(1993: 1133) has been adopted: trust is the mutual confidence that no party
to an exchange will exploit another’s vulnerabilities.
Parties to an exchange can be vulnerable in several different ways. For
example, when parties to an exchange find it very costly to accurately
evaluate the quality of the resources or assets others assert they will bring
to an exchange, these economic actors are subject to adverse selection
vulnerabilities (Akerlof 1970). When parties to an exchange find it very
costly to accurately evaluate the quality of the resources or assets others
are actually offering in an exchange, these economic actors are subject to
moral hazard vulnerabilities (Holmstrom 1979). Also, when parties to an
exchange make large, asymmetric transaction-specific investments in an
exchange, they are subject to holdup vulnerabilities (Klein, Crawford, and
Alchian 1978). According to Sabel, when parties to an exchange trust each
other, they share a mutual confidence that others will not exploit any
adverse selection, moral hazard, holdup, or any other vulnerabilities that
might exist in a particular exchange.
A definition of trustworthiness follows directly from Sabel’s definition of
trust. As the word itself implies, an exchange partner is trustworthy when
it is worthy of the trust of others. An exchange partner worthy of trust is
one that will not exploit other’s exchange vulnerabilities. Note that while
trust is an attribute of a relationship between exchange partners, trustwor-
thiness is an attribute of individual exchange partners.
In many ways opportunism is the opposite of trust. A firm’s actions
are opportunistic to the extent that they take advantage of another’s
exchange vulnerabilities. Williamson (1979) emphasizes firms exploit-
ing holdup vulnerabilities of exchange partners, caused by asymmetric
96 RBT AND ORGANIZATIONAL CAPABILITIES

transaction-specific investment. However, the exploitation of other


exchange vulnerabilities, including adverse selection and moral hazard
vulnerabilities, can also be opportunistic in nature.

Types of trust

While trust is the mutual confidence that one’s vulnerabilities will not be
exploited in an exchange, different types of trust can exist in different eco-
nomic exchanges. These different types of trust depend on different reasons
parties to an exchange can have the confidence that their vulnerabilities will
not be exploited. At least three types of trust can be identified: weak form
trust, semi-strong form trust, and strong form trust.

WEAK FORM TRUST: LIMITED OPPORTUNITIES FOR OPPORTUNISM


One reason that exchange partners can have the mutual confidence that
others will not exploit their vulnerabilities is that they have no significant
vulnerabilities, at least in a particular exchange. If there are no vulnerabil-
ities, from adverse selection, moral hazard, holdup, or other sources, then
the trustworthiness of exchange partners will be high, and trust will be the
norm in the exchange.
This type of trust can be called weak form trust because its existence
does not depend on the creation of contractual or other forms of exchange
governance. Nor does its existence depend on commitments by parties to
an exchange to trustworthy standards of behavior. Rather, trust emerges in
this type of exchange because there are limited opportunities for oppor-
tunism. Parties to an exchange, in this weak form context, will gain all the
benefits of being able to trust their exchange partners without substantial
governance or other costs.
Of course, weak form trust is likely to emerge in only very specific
kinds of exchanges, that is, exchanges where there are limited vulnerabil-
ities. In general, whenever the quality of goods or services that are being
exchanged can be evaluated at low cost, and whenever exchange partners
do not need to make transaction-specific investments to obtain gains from
an exchange, vulnerabilities in that exchange will be limited, and weak
TRUST 97

form trust will be common. Easy-to-evaluate quality effectively eliminates


adverse selection and moral hazard vulnerabilities; no transaction-specific
investments effectively eliminate holdup vulnerabilities. Without vulnera-
bilities, opportunistic behavior is unlikely, and weak form trustworthiness
will exist.
In this sense, weak form trust is clearly endogenous, that is, it emerges
out of a very specific exchange structure. Of course, this exchange structure
can change and evolve over time. If an exchange evolves such that the cost
of evaluating the quality of the goods or services in an exchange increases,
then adverse selection and/or moral hazard vulnerabilities may emerge,
making weak form trust no longer possible. Also, if transaction-specific
investments develop over time in an exchange, then holdup vulnerabilities
may emerge, and weak form trust will no longer exist.
Given this analysis, an important question becomes: how often will weak
form trustworthiness exist? While, ultimately, this is an empirical question,
it seems likely that weak form trust will be the norm in highly competitive
commodity markets (Williamson 1975). Examples of such markets include
the market for crude oil and the market for soybeans. In all these markets,
it is relatively easy for buyers and sellers to evaluate the quality of the goods
or services they are receiving. Moreover, in all these markets, there are large
numbers of equally qualified buyers and sellers. Thus, firms do not have to
make transaction-specific investments to trade with any one firm. Since
parties to exchanges in these kinds of markets are not subject to significant
exchange vulnerabilities, weak form trustworthiness is usually the norm.
Of course, that a market was once a highly competitive commodity mar-
ket does not mean that it will always be a highly competitive commodity
market. The cost of evaluating the quality of goods or services can increase,
the number of buyers or suppliers can fall, and significant exchange vul-
nerabilities can develop. In this new exchange context, exchange partners
cannot rely on the emergence of weak form trust, though other types of
trust may develop.

SEMI-STRONG TRUST: TRUST THROUGH GOVERNANCE


When significant exchange vulnerabilities exist (due to adverse selection,
moral hazard, holdup, or other sources), trust can still emerge, if parties
98 RBT AND ORGANIZATIONAL CAPABILITIES

to an exchange are protected through various governance devices. Gov-


ernance devices impose costs of various kinds on parties to an exchange
that behave opportunistically. If the appropriate governance devices are in
place, the cost of opportunistic behavior will be greater than its benefit,
and it will be in the rational self-interest of exchange partners to behave in
a trustworthy way (Hill 1990). In this context, parties to an exchange will
have the mutual confidence that their vulnerabilities will not be exploited
because it would be irrational to do so. This type of trust can be called
semi-strong trust, and is the type of trust emphasized in most economic
models of exchange (Hill 1990).
A wide range of governance devices have been described in the litera-
ture. Economists have tended to focus on market-based and contractual
governance devices. One market-based governance device is the market
for reputations (Klein, Crawford, and Alchian 1978). Firms or individu-
als that develop a reputation for behaving opportunistically will often be
excluded from future economic exchanges where exchange vulnerabilities
are significant. The cost of these opportunities forgone can be substan-
tial, and the avoidance of these costs can lead exchange partners to be
trustworthy in current exchanges, albeit in a semi-strong way. Examples of
more contractual forms of governance include complete contingent claims
contracts, sequential contracting, strategic alliances, and hierarchical gov-
ernance (Williamson 1985; Hennart 1988; Kogut 1988). Contractual gover-
nance devices explicitly define what constitutes opportunistic behavior in
a particular exchange, and specify the economic costs that will be imposed
on offending parties (Williamson 1979).
This economic focus on market-based and contractual governance
devices has been criticized as being badly under-socialized (Granovetter
1985). Several authors have suggested that a variety of social costs can also
be imposed on exchange partners that behave in opportunistic ways. For
example, a firm that gains a reputation as a ‘cheater’ may bear substantial
economic opportunity costs (Klein, Crawford, and Alchian 1978), but
it may also lose its social legitimacy (DiMaggio and Powell 1983). Also,
Granovetter (1985) has argued that exchange partners, be they individuals
or firms, that are deeply embedded in social networks put those networks
of relations at risk when they engage in opportunistic behavior. The impo-
sition of these social costs also acts to reduce the threat of opportunistic
behavior.
TRUST 99

One implication of including governance devices that impose social


costs on opportunistic exchange partners, instead of just economic costs,
is the expectation that opportunistic behavior will be unusual, even in
settings where few market-based or contractual governance devices are in
place, as long as these more social forms of governance exist (Granovetter
1985). Even some economists are beginning to recognize the importance
of these more socially-oriented forms of governance. However, while this
more social approach to governance broadens the range of governance
devices that should be studied, the trust that emerges among parties to
an exchange with these social governance mechanisms in place is of the
same type as the trust that emerges with only economic governance devices
in place. In both cases, trust emerges because rational actors find it in
their self-interest, for both economic and social reasons, to not behave
opportunistically. Put another way, neither economic nor behavioral schol-
ars would generally predict the emergence of trust in exchanges where
significant vulnerabilities exist, and in which there are no market-based,
contractual, or social forms of governance.2 With governance in place,
however, trust—of the semi-strong variety—may emerge, despite the exis-
tence of significant exchange vulnerabilities.
Like weak form trust, semi-strong trust is endogenous, that is, it emerges
out of the structure of a particular exchange. However, unlike weak form
trust, the structure of that exchange is modified, in the semi-strong case,
through the use of governance devices of various types. If parties to an
exchange create and/or exploit the correct governance devices, then oppor-
tunistic behavior in that exchange will be unlikely, and trust—albeit of the
semi-strong variety—will exist.
Of course, the creation and exploitation of different forms of governance
are not costless. The costs of market-based and contractual forms of gover-
nance are well documented (Williamson 1985). While social forms of gov-
ernance have fewer direct costs associated with them, they are nevertheless
costly, in the sense that the use of these forms of governance requires one to
only engage in exchanges where potential partners are embedded in specific
broader social networks of relations. This limitation on potential exchange
partners is an opportunity cost of using social forms of governance.
Traditional transactions cost logic suggests that rational economic actors
will insist on just that level of governance necessary to ensure the semi-
strong trustworthiness of exchange partners. If existing social forms of
100 RBT AND ORGANIZATIONAL CAPABILITIES

governance cannot assure the emergence of semi-strong trustworthiness,


then additional, and costly, legalistic and contractual forms of governance
(including, perhaps, contingent claims contracts and sequential contact-
ing) will need to be created. If this level of governance is not sufficient,
then even more costly hierarchical forms of governance may be erected
(Williamson 1975, 1979). There may even be some exchanges where
hierarchical governance is not sufficient to create semi-strong form trust
(Grossman and Hart 1986).
One implication of this form of analysis is that there may be some
potentially valuable exchanges that cannot be pursued. Whenever the cost
of governance needed to generate semi-strong trust is greater than the
expected gains from trade, an exchange with semi-strong trustworthy part-
ners will not be pursued. This can happen in at least two ways. First, the
expected gains from trade may be relatively small, in which case even mod-
est investments in governance mechanisms may not pay off. Second, the
expected gains from trade may be very large, but so may be the exchange
vulnerabilities in that trade. In this type of exchange, the high cost of
governance may still be greater than the expected value of exchange, even if
that expected value is large. Indeed, as Grossman and Hart (1986) suggest,
there may be some exchanges where no governance devices will create
semi-strong trust (i.e. where the cost of governance is infinitely high). If
the only types of trust that can exist in economic exchanges are of the weak
and semi-strong types, then these valuable, but costly to govern, exchanges
may have to remain unexploited.

STRONG FORM TRUST: HARD-CORE TRUSTWORTHINESS


In weak form trust, trust is possible because exchange vulnerabilities do
not exist. In the semi-strong case, trust is possible, despite exchange vul-
nerabilities, because of the significant social and economic governance
mechanisms on the opportunistic behavior of exchange partners. In strong
form trust, trust emerges in the face of significant exchange vulnerabil-
ities, independent of whether elaborate social and economic governance
mechanisms exist, because opportunistic behavior would violate values,
principles, and standards of behavior that have been internalized by parties
to an exchange.
TRUST 101

Strong form trust could also be called principled trust, since trust-
worthy behavior emerges in response to sets of principles and standards
that guide the behavior of exchange partners. Frank (1988) might call
strong form trust ‘hard-core trust’. Hard-core trustworthy exchange part-
ners are trustworthy, independent of whether exchange vulnerabilities
exist and independent of whether governance mechanisms exist. Rather,
hard-core trustworthy exchange partners are trustworthy because that is
who, or what, they are. This type of trust is, perhaps, closest to the type
of trust emphasized by behavioral scholars (Mahoney, Huff, and Huff
1993).3
In this sense, strong form trustworthiness is clearly exogenous to a par-
ticular exchange structure. Strong form trust does not emerge from the
structure of an exchange, but rather, reflects the values, principles, and
standards that partners bring to an exchange. Those values, principles,
and standards may reflect an exchange partner’s unique history, its culture,
or the personal beliefs and values of critical individuals associated with it
(Barney 1986b; Arthur 1989; Dierickx and Cool 1989).

The strong form trustworthiness of individuals


While the existence of strong form trustworthiness is, ultimately, an empir-
ical question, research from a variety of disciplines can be helpful in
answering the existence question. If exchange partners are individuals, then
research in developmental psychology suggests that strong form trustwor-
thiness can exist in at least some people.
Developmental psychologists have studied the stages of moral develop-
ment in children and young adults (Kohlberg 1969, 1971). These stages are
summarized in Table 5.1.4 When children are very young (small babies),
they are able to make very few, if any, moral choices. In this stage, decision-
making and behavior is essentially amoral. However, as children mature,
they often have to decide whether to conform their choices and behaviors
to a set of values, principles, and standards.5 In the conventional morality
stage (Kohlberg 1969), children conform their choices and behaviors to a
set of values, principles, and standards in order to avoid the costs imposed
on them by others for failing to do so. In this stage, children are moral
because the costs of being caught violating principles and standards (i.e.
punishment) are too high. In the postconventional morality stage, choices
102 RBT AND ORGANIZATIONAL CAPABILITIES

Table 5.1. Parallels between stages of moral development and types of trust

Stages in moral development Types of trust and trustworthiness

Amoral stage Weak form trust


When there are no moral choices to be Limited opportunities for opportunism
made
Conventional morality Semi-strong form trust
Decisions and behaviors conform to Trust emerges in response to social and
standards in order to avoid the cost of economic governance mechanisms that
being caught violating standards impose costs on opportunistic behavior
Postconventional morality Strong form trust
Decisions and behaviors conform to An exchange partner behaves in a trustworthy
standards because they have been manner because to do otherwise would be to
internalized as principles and values violate values, standards, and principles of
behavior

and behaviors conform to a set of values, principles, and standards because


they are internalized by individuals. While external costs could still be
imposed on choices and behaviors that do not conform to these principles
and standards, avoiding these costs is not the primary motivation for moral
behavior. Rather, the primary motivation for such behavior is to avoid
internally imposed costs, including a sense of personal failure, guilt, and
so forth.
Some obvious parallels exist between the types of trust and trustwor-
thiness identified here, and the stages of moral development identified in
developmental psychology. These parallels are identified in Table 5.1. The
amoral stage in the moral development literature is analogous to weak
form trustworthiness. Just as young children cannot violate moral stan-
dards when they are unable to make moral choices, individuals in exchange
relationships cannot act opportunistically when there are no opportunities
to do so. Conventional morality is analogous to semi-strong trustwor-
thiness. In conventional morality, individuals make choices to conform
their behavior to a set of principles and standards in order to avoid the
cost of failing to do so; in semi-strong trust, opportunistic behavior is
avoided because of the economic and social costs imposed on such behav-
ior by governance mechanisms. Finally, postconventional morality is anal-
ogous to strong form trustworthiness. In both cases, choices and behavior
conform to a set of principles and standards because those principles and
standards have been internalized. While external costs may be imposed
on individuals who violate these principles and standards, avoiding these
TRUST 103

external costs is not the primary reason choices and behavior conform to
them. Rather, the avoidance of internally imposed costs—including a sense
of personal failure and guilt—provide the primary motivation for this type
of principled behavior.
Psychologists have shown that postconventional morality is not uncom-
mon (Kohlberg 1971). While some people never mature beyond the amoral
or conventional morality stages, many have sets of values, principles, and
standards that they use to guide their choices and behaviors. In order
for postconventional morality to lead to strong form trustworthiness, all
that is additionally required is that some of these values, principles, and
standards suggest that exploiting an exchange partner’s vulnerabilities is
inappropriate.

The strong form trustworthiness of firms


At the individual level, the existence of strong form trustworthiness in at
least some people seems plausible. However, that individuals—as exchange
partners—can be strong form trustworthy does not necessarily imply that
firms—as exchange partners—can be strong form trustworthy. Firms, as
exchange partners, can be strong form trustworthy for at least two rea-
sons. Either a firm may possess a culture and associated control systems
that reward strong form trustworthy behavior, or the specific individuals
involved in a particular exchange may, themselves, be strong form trust-
worthy.
Zucker (1987) has shown that firm founders can have a very strong
impact on the culture and other institutional attributes of firms. This
impact can continue, even if these individuals have been dead for many
years. Others, besides founders can also have strong cultural and institu-
tional effects. For example, transformational leaders (Tichy and Devanna
1986) can have the effect of recreating a firm’s culture and fundamentally
changing other of its attributes.
If these and other influential individuals were themselves strong form
trustworthy, they may have created an organizational culture character-
ized by strong form trustworthy values and beliefs. These strong form
trustworthy values and beliefs may also be supported and reinforced by
internal reward and compensation systems, together with decision-making
mechanisms that reflect strong form trustworthy standards. A firm with
104 RBT AND ORGANIZATIONAL CAPABILITIES

these cultural and institutional mechanisms in place will often behave in a


strong form trustworthy manner in exchange relationships.
Note that if a firm has a strong form trustworthy culture and associated
control mechanisms, it is not necessary for each individual in a firm to
be strong form trustworthy. Rather, all that is required is that individuals
in a firm be at least self-interested in their behavior. In this situation,
individuals in a firm will find it in their self-interest to behave in a strong
form trustworthy way when representing the firm, for failure to do so
would lead them to be subject to a variety of social and economic sanctions.
Individuals who are unable to conform themselves to a firm’s strong form
trustworthy standards have several options, including, for example, finding
positions in the firm where trustworthiness issues are not likely to arise or
changing firms.
Of course, that a firm once had a culture, and associated internal control
mechanisms, that encouraged strong form trustworthiness does not mean
that it will always have these attributes. Cultures can evolve, control mech-
anisms can change, and a firm may no longer have the attributes to qualify
for strong form trustworthiness. However, even when firms do not have
strong form trustworthiness cultures, it may still be possible for some of
the exchanges in which a firm engages to be characterized by strong form
trust.
Exchanges between firms are, more often than not, actually exchanges
between small groups of individuals in different firms. For example, when
an automobile company signs a supply agreement with a supplier, the
two groups of individuals most directly involved in this agreement are
the purchasing people, in the automobile company, and the sales peo-
ple, in the supply company. When two firms agree to form an equity
joint venture, several groups of people are directly involved, including
those in each parent firm that are assigned the responsibility to inter-
act with the joint venture, and those that work in the joint venture
itself.
While the firms in these exchanges may not have strong form trust-
worthy cultures, the specific individuals who are most directly involved in
these exchanges may, themselves, be strong form trustworthy. Exchanges
between strong form trustworthy individuals in different firms can lead to
strong form trust, even though the firms, themselves, may not be strong
form trustworthy.6
TRUST 105

Trust and competitive advantage

Trust can emerge in economic exchanges in any of the three ways discussed.
However, these three types of trust are not equally likely to be sources of
competitive advantage. A strategic analysis of trust and trustworthiness
focuses on the conditions under which a particular type of trust will be
a source of competitive advantage.

WEAK FORM TRUST AND COMPETITIVE ADVANTAGE


The exchange attributes that make weak form trust possible suggest that
weak form trust will usually not be a source of competitive advantage.
As suggested earlier, weak form trust is most likely to emerge in highly
competitive commodity markets. It is well known that exchange partners
in highly competitive commodity markets can expect to gain few, if any,
competitive advantages (Porter 1980). In particular, while those partici-
pating in these markets will be able to rely on the existence of weak form
trust in their exchange relationships, the advantages of weak form trust will
accrue to all exchange partners in these markets equally, thereby giving no
one of them a competitive advantage.
Indeed one of the few ways those trading in these markets can expect to
gain advantages from weak form trust is if some competitors fail to rely on
weak form trust and, indeed, invest in unnecessary and costly governance
devices to create semi-strong form trust. Both those that rely on weak
form and semi-strong form trust, in these highly competitive commodity
markets, can expect trust to exist in their exchange relationships. However,
those that invest in governance to generate semi-strong form trust will
have higher costs compared to those that rely on weak form trust. Over
time, those that have invested in unnecessary (and costly) governance
will either abandon those governance devices or suffer from competitive
disadvantages.
Put differently, the cost advantage of those that rely on weak form trust
over those that rely on semi-strong form trust, in these highly competitive
conditions, is a measure of the economic value of weak form trust. How-
ever, if numerous competitors are all able to obtain this value at the same
low cost, then it will not be a source of competitive advantage to any one
of them (Barney 1991b).
106 RBT AND ORGANIZATIONAL CAPABILITIES

SEMI-STRONG FORM TRUST AND COMPETITIVE ADVANTAGE


Semi-strong trust in exchange relationships is economically valuable, in the
sense that its creation assures parties to an exchange that their vulnerabil-
ities will not be exploited. However, the ability to create semi-strong trust
in economic exchanges depends on several important governance skills
and abilities that parties to an exchange must possess. For example, for
semi-strong trust to emerge, exchange partners must be able to accurately
anticipate sources and levels of opportunistic threat in the exchanges in
which they may participate. Also, to create semi-strong trust, exchange
partners must be able to rely on existing social governance mechanisms,
and/or to conceive of, implement, and manage the appropriate market-
based and contractual governance mechanisms. Only if exchange partners
can accomplish these tasks will the ‘right’ types of governance be chosen to
create semi-strong trust, and will the value of semi-strong trust be realized.
However, for semi-strong trust to be a source of competitive advantage,
there must be heterogeneity in the exchange governance skills and abilities
of competing firms (Barney 1991b). If most competing firms or individuals
have similar governance skills and abilities, they will all be equally able to
create the conditions under which semi-strong trust will emerge in their
exchange relationships. Moreover, the cost of creating semi-strong trust
will also not vary dramatically across these equally skilled competitors.
Since these competitors do not vary in their exchange governance skills,
no one of them will be able to gain a competitive advantage based on the
semi-strong trust that they are able to create with these skills.7
Of course, there is no reason to believe, a priori, that competing
exchange partners will be equally skilled or able in creating the conditions
necessary for semi-strong trust. For example, some exchange partners may
have developed a high degree of skill in managing, say, intermediate market
forms of governance (e.g. equity joint ventures). These highly skilled actors
may be able to create semi-strong trust using these intermediate market
forms of governance in economic exchanges where less skilled actors may
be forced to use hierarchical forms of governance. If intermediate market
forms of governance are, in fact, less costly than hierarchical forms of
governance, those that obtain semi-strong trust through intermediate mar-
ket forms will have a competitive advantage over those that must obtain
trust in that exchange through hierarchical forms of governance. Similar
TRUST 107

reasoning could apply to those that are highly skilled in managing contrac-
tual forms of governance (e.g. contingent claims contracts) compared to
those that are only able to use more costly intermediate market forms of
governance or hierarchical forms of governance.
Heterogeneity in the skills and ability to create semi-strong form trust
in an exchange may also reflect important social differences among
exchange partners. For example, if a particular firm is contemplating an
exchange with another firm, where that relationship is deeply embed-
ded in a large complex network of social relations, these firms may be
able to rely on (relatively inexpensive) social governance mechanisms to
develop semi-strong form trust. On the other hand, if a competing firm
is anticipating a similar exchange that is not deeply embedded in this
broader social network of relations, parties to this exchange may have to
rely on (more costly) economic forms of governance to ensure semi-strong
form trust. The firm that can rely on social governance to generate semi-
strong form trust will have a cost-based competitive advantage over the
firm that must rely on economic governance to generate semi-strong form
trust.
Heterogeneity in governance skills and abilities is an important expla-
nation of variance in a wide variety of different economic exchanges.
Compare, for example, the exchanges between Toyota and its suppliers,
on the one hand, and General Motors (GM) and its suppliers (Womack,
Jones, and Roos 1990; Dyer and Ouchi 1993), on the other. Toyota’s supply
relationships are deeply embedded in long-standing networks of social and
economic relationships. These social governance mechanisms have enabled
both Toyota and its suppliers to engage in very vulnerable exchanges (due
to high transaction-specific investments that lead to a high risk of holdup)
with substantially less contractual or other forms of governance than is
the case at GM. Without the ability to rely on social embeddedness to
constrain the opportunistic behavior of its suppliers, GM has had to reduce
the threat of opportunism by reducing the level of transaction-specific
investment in its suppliers (i.e. by having multiple competing suppliers), by
insisting on elaborate contractual protections, or by vertically integrating
the supply relationship (Womack, Jones, and Roos 1990; Dyer and Ouchi
1993). Overall, the cost of creating semi-strong form trust at Toyota has
been substantially lower than the cost of creating semi-strong trust at
GM.8
108 RBT AND ORGANIZATIONAL CAPABILITIES

Of course, if several competitors all possess these special governance


skills and abilities to approximately the same level, then they will not be
a source of competitive advantage for any of them, even if there are some
competitors who do not possess these skills. However, as long as the num-
ber of competitors that have these special governance skills and abilities is
less than what is required to generate perfect competition dynamics, then
they can be a source of competitive advantage for those that possess them
(Barney 1991b).
Moreover, if these skills and abilities can rapidly diffuse among
competitors, they will be the source of only temporary competitive
advantages. However, it seems likely that these skills and abilities will not
diffuse through most populations. For example, the ability to rely on social
governance mechanisms in different exchanges depends on the structure
of the network of relations within which an exchange is embedded. Those
networks of relations, in turn, are developed over long periods, and are
unique to a particular point in history. Such path-dependent (Arthur 1989)
phenomena are subject to time decompression diseconomies (Dierickx
and Cool 1989), and thus costly to imitate. The development of special
governance skills is also path-dependent. Moreover, these skills are often
socially complex, and thus costly to imitate (Barney 1991b).
Whenever exchange partners possess rare and costly-to-imitate gover-
nance skills and abilities, they may be able to use those abilities to gain
competitive advantages in creating semi-strong trust. On the other hand,
when competing exchange partners possess similar governance skills and
abilities, the creation of semi-strong trust will generate only competitive
parity.

STRONG FORM TRUST AND COMPETITIVE ADVANTAGE


For strong form trustworthiness to be economically valuable, all those
with a significant stake in an exchange must be strong form trustworthy.
If one or more parties to an exchange may behave opportunistically in that
exchange, then all parties to that exchange will need to invest in a variety
of social and economic governance mechanisms to ensure semi-strong
trust. Any potential economic advantages of being strong form trustworthy
are irrelevant when semi-strong governance protections are erected and
TRUST 109

exploited, since strong form trustworthy parties are forced to behave as if


they were only semi-strong trustworthy.

Economic opportunities in strong form trust exchanges


On the other hand, if all those with a significant stake in an exchange are
strong form trustworthy, some important and valuable economic oppor-
tunities may exist. These opportunities reflect either the governance cost
advantages that strong form trust exchanges may enjoy over semi-strong
form trust exchanges, or the ability that strong form trustworthy exchange
partners may have to explore exchange options not available to semi-strong
form trustworthy exchange partners.
When two or more strong form trustworthy individuals or firms engage
in an exchange, they can all be assured that any vulnerabilities that might
exist in this exchange will not be exploited by their partners. Moreover,
this assurance comes with no additional investment in social or economic
forms of governance. As long as the cost of developing and maintaining
strong form trustworthiness in an individual or firm, plus the cost of dis-
covering strong form trustworthy partners, is less than the cost of exploit-
ing or creating semi-strong form governance devices, those engaging in
a strong form trustworthy context will gain a cost advantage over those
exchanging in a semi-strong trustworthy context.
Consider, for example, several competing firms looking to purchase raw
materials from a set of suppliers. Suppose that a small number of these
buyers and sellers are strong form trustworthy, and that there are some
significant exchange vulnerabilities in this raw materials purchase. In order
to complete this purchase, those purchasing from semi-strong suppliers
will need to rely on or erect a variety of social and economic governance
devices. While these governance devices are costly, their existence will
enable firms to purchase the raw material in question. On the other hand,
strong form trustworthy buyers purchasing from strong form trustworthy
suppliers will not have to rely on or erect social or economic forms of
governance in order to complete their purchase of the raw material. As long
as the cost of developing and maintaining strong form trustworthiness,
plus the cost of discovering strong form trustworthy exchange partners,
is less than the cost of relying on or erecting social or economic governance
devices, the firms purchasing raw materials in a strong form trust exchange
110 RBT AND ORGANIZATIONAL CAPABILITIES

will have a cost advantage over those firms purchasing raw materials in a
semi-strong trust exchange.9
Perhaps even more important than this governance cost advantage,
those engaging in strong form trust exchanges may be able to exploit
exchange opportunities that are not available to those who are only able
to engage in semi-strong trust exchanges. It has already been suggested
that valuable semi-strong exchanges will not be pursued when the cost
of governance needed to generate semi-strong trust is greater than the
expected gains from trade. This can happen when the expected gains from
trade are small (but modest vulnerabilities in this exchange require modest
levels of expensive governance) or when the expected gains from trade are
substantial (but very large vulnerabilities in this exchange require very sub-
stantial levels of costly governance). While semi-strong trust exchanges will
not be pursued in these situations, it may be possible to pursue strong form
trust exchanges. In this sense, strong form trustworthiness may increase the
set of exchange opportunities available to an individual or firm, compared
to those who are only semi-strong trustworthy (Zajac and Olsen 1993; Ring
and Van de Ven 1994).
Consider, for example, several competing firms looking to cooperate
with one or more of several other firms in the development and exploita-
tion of a new, and sophisticated, technology. Suppose that only a small
number of these two sets of firms are strong form trustworthy, that the
technology in question has significant economic potential, but that there
are enormous exchange vulnerabilities in the technology development
process. Semi-strong trustworthy firms, in this setting, will need to invest
in substantial amounts of costly governance to try to create semi-strong
trust. It may even be the case that no form of governance will create semi-
strong trust (Grossman and Hart 1986). The potential economic return
that could be obtained from this exchange will need to be reduced by an
amount equal to the present value of the cost of governing this exchange.
Moreover, the present value of this exchange will also have to be discounted
by any residual threat of opportunism. The reduced value of this exchange
could lead semi-strong trustworthy firms to decide not to pursue it, even
though substantial economic value may exist.
On the other hand, exchanges of this sort between strong form trust-
worthy firms are burdened neither by the high cost of governance nor
any residual threat of opportunism. Strong form trustworthy firms will
TRUST 111

be able to pursue these valuable, but highly vulnerable exchanges, while


semi-strong form trustworthy firms will be unable to pursue them. This
may represent a substantial opportunity cost for semi-strong trustworthy
exchange partners, and a source of competitive advantage for strong form
trustworthy exchange partners.10
Traditional transactions cost logic suggests that when faced with these
valuable but highly vulnerable exchanges, exchange partners will opt for
hierarchical forms of governance and use managerial fiat as a way to man-
age trustworthiness problems (Williamson 1985). However, hierarchical
governance is not always a solution to these problems. First, there may be
important legal and political restrictions on the use of hierarchical gover-
nance. For example, one cannot acquire a direct competitor if such actions
lead to unacceptably high levels of industry concentration. Also, firms
may be required, for political reasons, to maintain market or intermediate
market relationships with an exchange partner (e.g. when entering into a
new country market).
Second, as Grossman and Hart (1986) suggest, hierarchical gover-
nance does not necessarily ‘solve’ opportunism problems. Rather, it simply
shifts those problems from a market or intermediate market context to
inside the boundaries of the firm. Where, in market-based exchanges, firms
face the threat of opportunism in exchanges with other firms, bringing
these transactions within the boundaries of a firm can simply lead to
division facing the threat of opportunism in exchanges with other divi-
sions. Put differently, hierarchical governance does not automatically create
strong form trust exchanges (Ouchi 1980). These issues are discussed in
more detail in section the ‘Discussion’ section of Chapter 8 which provides
a resource-based analysis of vertical integration.
Where hierarchical governance may not always be a solution to the threat
of opportunism, exchanges between strong form trustworthy exchange
partners—whether those exchanges are within the boundary of a sin-
gle firm or not—will, in general, create strong form trust. Strong form
trustworthy individuals or firms will often be able to gain governance
cost advantages over semi-strong trustworthy individuals or firms. More-
over, strong form trustworthy individuals or firms will often be able to
engage in economic exchanges that cannot be pursued by semi-strong
trustworthy exchange partners. Put differently, the level of vulnerability in
some economic exchanges may be greater than the ability of any standard
112 RBT AND ORGANIZATIONAL CAPABILITIES

governance devices to protect against the threat of opportunism. The only


way to pursue these exchanges is through strong form trustworthiness.
Of course, if most competitors are strong form trustworthy, and engage
in exchanges with others that are also strong form trustworthy, then the
advantages of strong form trustworthiness would only be a source of com-
petitive parity, and not competitive advantage. However, while the number
of strong form trustworthy exchange partners in a particular segment of
the economy is ultimately an empirical question, it seems like a reasonable
guess that strong form trustworthiness in at least some segments of the
economy is probably rare, and thus (assuming exchanges with other strong
form trustworthy exchange partners are developed) at least a source of
temporary competitive advantage for strong form trustworthy individuals
and firms.

Locating strong form trustworthy exchange partners


Given the important competitive advantages that may attend exchanges
between strong form trustworthy exchange partners, an important ques-
tion becomes: how can strong form trustworthy exchange partners recog-
nize each other? This process is problematic, since exchange partners that
are not strong form trustworthy have a strong incentive to assert that
they are. If a strong form trustworthy individual or firm believes that an
exchange partner is strong form trustworthy, even though this partner is
not, then that strong form trustworthy individual or firm will be willing to
engage in a highly vulnerable exchange without social or economic devices.
Without these devices in place, the untrustworthy exchange partner could
exploit the strong form trustworthy partner’s exchange vulnerabilities with
impunity. Thus, simple assertions that one is strong form trustworthy are
not sufficient for assuming that an exchange partner is, in fact, strong form
trustworthy.
Of course, a simple solution to this adverse selection problem would be
to directly observe whether a potential exchange partner is strong form
trustworthy, and respond appropriately. Unfortunately, the individual
and organizational attributes that create strong form trustworthiness are
difficult to directly observe. At an individual level, the values, princi-
ples, and standards around which strong form trustworthy individuals
organize their lives are clearly not directly observable. At the firm level,
TRUST 113

an organization’s culture, and associated control systems, may be difficult


to observe, and their implications for individual behavior ambiguous—
at least to those not deeply embedded in this culture and control system.
Moreover, if the development of strong form trust depends on the strong
form trustworthiness of small groups of people in a larger organization,
evaluating the individual values, principles, and standards of these people
remains difficult.
Even with these challenges, strong form trustworthy exchange partners
can still be found. It will often be the case, for example, that exchange
partners will begin a relationship assuming that others are at least semi-
strong trustworthy. As this relationship evolves over time, parties to an
exchange may be able to gain sufficient information to accurately judge
whether others are strong form trustworthy. If two or more parties to
an exchange discover that they are strong form trustworthy, any subse-
quent exchanges between these parties can generate strong form trust,
and these exchange partners will subsequently obtain all the advantages
of strong form trustworthiness. On the other hand, if experience shows
that an exchange partner is only semi-strong form trustworthy, then future
exchanges with this partner will continue with semi-strong form trust
generating governance mechanism in place.
Note that this process of discovering strong form trustworthy exchange
partners assumes that one’s trustworthiness type does not automatically
change as a result of experience in a semi-strong trust relationship. If the
creation of semi-strong trust exchanges inevitably led exchange partners to
become strong form trustworthy, then all exchanges would inevitably be
characterized by strong form trust, and strong form trustworthiness would
not be a source of competitive advantage to any individual or firm. Rather
than changing an exchange partner’s trustworthiness type, the creation of a
semi-strong trust exchange creates an opportunity for exchange partners to
more directly observe another’s trustworthiness type. While it is certainly
true that an exchange partner’s trustworthiness type may evolve over the
long run, the historical, path-dependent, socially complex, and causally
ambiguous nature of strong form trustworthiness makes it unlikely that
semi-strong form trustworthy firms will be able to become strong form
trustworthy in the short or medium term.
This search for potential strong form trustworthy exchange partners can
be shortened through the use of signals of strong form trustworthiness
114 RBT AND ORGANIZATIONAL CAPABILITIES

(Spence 1973). Signals of strong form trustworthiness must have two


properties: (a) they must be correlated with the underlying (but costly to
observe) actual level of strong form trustworthiness in a potential exchange
partner, and (b) they must be less costly to exchange partners that are
actually strong form trustworthy than they are to exchange partners that
only claim they are strong form trustworthy (Spence 1973).
Several behaviors by exchange partners qualify as signals for strong
form trustworthiness. For example, a reputation for being strong form
trustworthy is a signal of strong form trustworthiness.11 Gaining a repu-
tation as a strong form trustworthy exchange partner occurs, over time, as
an exchange partner confronts situations where opportunistic behavior is
possible, but chooses not to engage in opportunistic activities. There are
no opportunity costs associated with a strong form trustworthy individual
or firm not behaving opportunistically, since such behavior is not in this
kind of exchange partner’s opportunity set. On the other hand, a non-
strong form trustworthy exchange partner will have to absorb opportu-
nity costs each time they decide to not behave in an opportunistic way.
These opportunity costs make it more costly for an exchange partner that
is not strong form trustworthy to develop a reputation as strong form
trustworthy, compared to an exchange partner that is actually strong form
trustworthy.
While a reputation for being strong form trustworthy is a signal of strong
form trustworthiness, it is noisy. In particular, this reputation cannot dis-
tinguish between those exchange partners that are actually strong form
trustworthy, and those that are not strong form trustworthy, but have yet
to engage in an exchange where returns to opportunistic behavior are large
enough to motivate opportunistic behavior. While a reputation for being
strong form trustworthy does eliminate those exchange partners who have
acted opportunistically, it does not eliminate those exchange partners who
might act opportunistically, given the right incentives.
Another signal of strong form trustworthiness is being open to outside
auditing of the exchange relationship. This is less costly to strong form
trustworthy exchange partners, compared to those that are not strong form
trustworthy, since trustworthy exchange partners were not going to behave
opportunistically anyway. One would expect to see strong form trustwor-
thy firms and individuals to be very open to outside auditors, perhaps even
paying the cost of outside auditors chosen by potential exchange partners.
TRUST 115

A third signal of strong form trustworthiness might be to make unilat-


eral transaction-specific investments in an exchange before that exchange
is actually in place. Gulati, Khana, and Nohira (1994) have found, for
example, that it is not uncommon for firms with a strong track record
of successfully engaging in joint ventures to sign long-term, third-party
supply contracts that are only valuable if a particular joint venture actually
goes forward—before that joint venture agreement is complete. Such uni-
lateral transaction-specific investments are less costly to strong form trust-
worthy firms, since they were not going to behave in an opportunistic
manner in developing this joint venture anyway. These investments
foreclose opportunistic opportunities for firms that are not strong form
trustworthy, and thus represent significant opportunity costs to these
firms. If all those involved in an exchange independently make these kinds
of unilateral transaction-specific investments, the others in these exchanges
can conclude, with some reliability, that they are strong form trustworthy.
If strong form trustworthiness is relatively rare among a set of competi-
tors, and if two or more strong form trustworthy exchange partners are
able to engage in trade, then these strong form trustworthy individuals or
firms will gain at least a temporary competitive advantage over individ-
uals or firms that are not strong form trustworthy. For this competitive
advantage to remain, however, the individual and organizational attributes
that make strong form trustworthiness possible must also be costly to
imitate and immune from rapid diffusion. Fortunately, the individual and
organizational attributes that make strong form trustworthiness possible
(i.e. individual values, principles, and standards; an organization’s culture
and associated control systems) reflect an exchange partner’s unique path
through history (path dependence) and are socially complex. As was sug-
gested earlier, these types of individual and organizational attributes are
usually immune from imitation and rapid diffusion among competitors
(Arthur 1989; Dierickx and Cool 1989; Barney 1991b).12

Discussion

Trust, in economic exchanges, can be a source of competitive advantage.


However, trust in these exchanges is not always a source of competi-
tive advantage. Weak form trust is only a competitive advantage when
116 RBT AND ORGANIZATIONAL CAPABILITIES

competitors invest in unnecessary and costly semi-strong governance


mechanisms. Semi-strong form trust is only a source of competitive advan-
tage when a small number of competitors have special skills and abilities in
conceiving of and implementing social and economic governance devices,
and when those skills and abilities are immune from low-cost imitation.
Strong form trust is a source of competitive advantage when two or
more strong form trustworthy individuals or firms engage in an exchange,
when strong form trustworthiness is relatively rare among a set of com-
petitors, and when the individual and organizational attributes that lead to
strong form trustworthiness are immune from low-cost imitation.
This analysis has important implications for research in organization
theory and strategic management. For example, these ideas can be seen
as an extension of transactions cost theory—an extension that makes this
form of analysis strategically more relevant. Where transactions cost eco-
nomics (TCE) implicitly assumes that the skills and abilities needed to
conceive of and implement governance mechanisms are constant across
individuals and firms (Williamson 1985), this approach suggests that these
skills and abilities may vary in some strategically important ways. Also,
where transactions cost theory assumes either that all potential exchange
partners are equally likely to behave opportunistically or that one cannot
distinguish between those that will behave opportunistically and those that
will not behave opportunistically (Williamson 1985), this analysis sug-
gests that potential exchange partners opportunistic tendencies may vary
and that these differences can be discovered. Discovery of exchange part-
ners that will not engage in opportunistic behavior enables firms to gain all
the advantages of trade, without the cost of governance.
Thus, consistent with many of the more behaviorally oriented organiza-
tional scholars cited earlier, the approach in this chapter rejects both the
assumption that all exchange partners are likely to engage in opportunistic
behavior and the assumption that it is not possible to know how oppor-
tunistic a particular exchange partner is likely to be. However, these trans-
actions cost assumptions are not replaced by equally extreme, if opposite,
assumptions that most exchange partners are trustworthy most of the time.
Rather, the approach adopted here is that the trustworthiness of exchange
partners can vary, and that how trustworthy an exchange partner is can
be discovered. The adoption of this approach leads to the conclusion that,
in some circumstances, trust can be a source of competitive advantage—a
TRUST 117

conclusion that is not possible if it is assumed that most exchange partners


are either untrustworthy or trustworthy.
This analysis also points to two important exchange processes that have
not received sufficient attention in the organizations and strategy litera-
tures. First, the argument suggests that semi-strong form trust can be a
source of competitive advantage if competing exchange partners vary in
their skills and abilities in conceiving of and implementing governance
mechanisms. What these specific skills and abilities might be, and why
they might develop in some economic actors and not others, are unex-
plored issues in this chapter. However, casual observation suggests that,
for example, some firms seem to be better at managing certain kinds of
governance devices than others. Corning seems to be able to manage joint
ventures more effectively than, say, TRW (Sherman 1992). Toyota seems
to be able to manage complex supply relationships more effectively than
GM (Womack, Jones, and Roos 1990; Dyer and Ouchi 1993). How these
different skills and abilities evolve, and their competitive implications, are
important research questions. In this context, comparative research on
semi-strong form governance in different industries and different countries
is likely to be very important (Dyer and Ouchi 1993).
Second, the argument suggests that strong form trustworthy exchange
partners may be able to discover other strong form trustworthy exchange
partners. Once discovered, these kinds of exchange partners can gain
important competitive advantages from working with each other. However,
much more empirical work needs to focus on the process through which
strong form trustworthiness evolves in an economic actor. Such empirical
work will establish whether strong form trustworthiness is a relatively sta-
ble attribute of economic actors, and whether this attribute can be imitated
at low cost. Also, empirical research needs to focus on the process of search-
ing for strong form trustworthy exchange partners. In particular, the role of
signals of strong form trustworthiness deserves empirical attention. In this
context it may be helpful to compare the decisions and behaviors of firms
that have been able to develop many strong form trustworthy exchanges
(e.g. Corning) with the decisions and behaviors of firms that have been
unable to develop these strong form trustworthy exchanges.
By examining the competitive implications of different types of trust
in economic exchanges, it becomes clear that extreme assumptions about
potential exchange partners—that most are trustworthy and that most
118 RBT AND ORGANIZATIONAL CAPABILITIES

are opportunistic—are overly simplistic. Rather, the trustworthiness of


exchange partners may vary, and in that variance, the possibility of com-
petitive advantage may exist.

NOTES

1. With apologies to Eugene Fama (1970).


2. Granovetter (1985) would probably argue that relatively few economic exchanges
are not embedded in some broader network of social relations. This, of course, is
ultimately an empirical question. However, Granovetter’s theory suggests that with-
out some mechanism to impose social costs on those that behave opportunistically,
social governance will not generate trust in a relationship.
3. In principle, some level of compensation will always exist where strong form trust-
worthy exchange partners will abandon their values, principles, and standards of
behavior, and act in opportunistic ways. This level of compensation might be called
the ‘Faustian’ price. However, this level of compensation is much higher for a
strong form trustworthy exchange partner compared to a semi-strong trustworthy
exchange partner.
4. This is a simplification of the actual typology developed by Kohlberg (1969, 1971).
However, it is consistent with Kohlberg’s findings.
5. These values, standards, and principles are normally taken from a child’s parents or
other caregivers (Kohlberg 1969).
6. Conflicts between individual and firm values, in this context, act as a constraint on
the ability of strong form trustworthy individuals to engage in strong form trust
exchanges. However, strong form trustworthy individuals can be expected to engage
in a variety of activities to neutralize the non-strong form trustworthy effects of
the firm within which they operate. Moreover, the firm has strong incentives to let
the strong form trustworthy individuals continue in strong form trust exchanges,
since it gains all the advantages of these exchanges.
7. Competing exchange partners do not have to erect the same governance mech-
anisms for semi-strong trust to generate competitive parity. Rather, all that is
required is that competing exchange partners erect functionally equivalent gover-
nance devices (i.e. governance devices that generate the same level of semi-strong
form trust) and that these governance devices are about equally costly. These argu-
ments also apply to bundles of governance devices to create semi-strong form trust.
8. Obviously, there may be some strong form trustworthiness attributes to Toyota’s
relationships with its suppliers that do not exist between GM and its suppliers.
9. While ultimately an empirical question, it seems likely that the cost of creating
and maintaining strong form trustworthiness, plus the cost of discovering strong
form trustworthy exchange partners, will often be less than the cost of relying on
or erecting semi-strong governance devices. The cost of creating and maintaining
strong form trustworthiness can be spread across numerous economic exchanges,
TRUST 119

thus reducing the per exchange cost. The cost of discovering strong form trustworthy
exchange partners can be reduced through the discovery and signaling mechanisms
described below.
10. As previously, it seems likely that the cost of creating and maintaining strong form
trustworthiness, plus the cost of discovering strong form trustworthy exchange
partners, will be less than the opportunity cost of relying only on semi-strong form
trust governance devices.
11. Note that a reputation for being strong form trustworthy is not the same as not
having a reputation for being opportunistic. A potential exchange partner may not
have a reputation for being opportunistic (they may not be known as a cheater), but
still not have a reputation for being strong form trustworthy (i.e. they may not be
known as ‘hard-core’ trustworthy).
12. Given the challenge of discovering strong form trustworthy exchange partners, these
relationships are likely to be relatively stable over time. Indeed, it may well be the
case that exchanges between strong form trustworthy partners may continue, even
though they have limited potential for generating current economic value (Ring
and Van de Ven 1994). In this setting, the challenge facing exchange partners is
to discover new ways to generate economic value with older, stable, relationships.
Even when this cannot be done, economically nonviable exchanges may continue
for sometime because of the close relationships between partners.
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6 Human resources as a
source of sustained
competitive
advantage∗

Human resource researchers and managers have long maintained that the
HR function plays an important role in firm performance. In fact, most
corporate annual reports boldly state that the firm’s people are its most
important asset. Despite these widely held beliefs and all-too-frequent
statements, however, many organizational decisions suggest a relatively low
priority on both the human resources of the firm and the HR department.
For example, when organizations require cost cutting, they often look first
to investments in the firm’s people such as training, wages, and headcounts.
In addition, even when top managers value the firm’s people, they may
not value the HR department. For example, when asked how the founder
and CEO of one of the most successful high-technology companies in the
world viewed the importance of human resources, the director of Strategic
Leadership Development replied:

Which do you mean? If you mean the Human Resource function, or what we
call ‘big HR’, then he doesn’t have much value for them at all. If you mean the
people of the company, or what we call ‘little hr’, then he places an extremely
high value on them.

If top managers publicly espouse their commitment to the firm’s human


resources, and the firm’s HR function has substantial responsibility for
managing this valuable firm resource, then why do many organizational
decisions not evidence this stated commitment to people or a respect for
the HR function?
∗ This chapter draws from Barney and Wright (1998).
122 RBT AND ORGANIZATIONAL CAPABILITIES

It may be that the fault lies, in part, with the fact that few HR executives
can explain, in economic terms, how a firm’s people can provide sustain-
able competitive advantage and the role that the HR function plays in this
process. Furthermore, due to this lack of understanding, many HR exec-
utives may fail to direct HR activities toward developing characteristics of
the firm’s human resources that can be a source of sustainable competitive
advantage.
In this chapter, the role of human resources in a firm’s competi-
tive advantage is examined. Following numerous HR scholars (e.g. Lado
and Wilson 1994; Wright, McMahan, and McWilliams 1994; Jackson
and Schuler 1995; Boxall 1996, 1998; Snell, Youndt, and Wright 1996;
Huselid, Jackson, and Schuler 1997; Boxall and Steeneveld 1999; Lepak
and Snell 1999; McMahan, Virich, and Wright 1999; Wright, Dunford, and
Snell 2001; Hatch and Dyer 2004), resource-based theory—as outlined in
Part I—is used to accomplish this analysis. Following this previous work,
a firm’s human resources are defined as all of the knowledge, experience,
skill, and commitment of a firm’s employees, their relationships with each
other, and with those outside the firm. A firm’s HR practices are defined
as all of the programs, policies, procedures, and activities that firms use to
manage their human resources.

Resource-based analysis of human resources

THE ECONOMIC VALUE OF HUMAN RESOURCES


Firms create value by either decreasing product/service costs or differenti-
ating the product/service in a way that allows the firm to charge a premium
price. Thus, the ultimate goal of any HR executive is to create value through
the HR function. The first question that an HR executive must address
is ‘How can the HR function aid in either decreasing costs or increasing
revenues?’
Alcon Laboratories exemplifies the role of HR practices in directly
decreasing costs. Trying to hold down the cost of health insurance, Alcon
sought to encourage employees to take part in the less expensive Preferred
Provider Organization (PPO) rather than the traditional fee-for-service
type plans. Vice-president of HR, Jack Walters, noticed that many doctors
HUMAN RESOURCES 123

who were part of the PPO were not the doctors being used by employ-
ees. Thus, in negotiations, he asked MetLife to identify the doctors Alcon
employees were using and recruit those doctors into the PPO. MetLife
was able to bring most of those doctors into its PPO, and, as a result,
Alcon’s health insurance costs increased at less than half of the industry
average.
Increasing revenues, on the other hand, is a more distant goal to HR
managers but one in which they can play an important role. For exam-
ple, Federal Express (now FedEx) illustrates the value created by human
resources. Federal Express managers stress that they are a ‘people-first’
organization. The corporate philosophy statement sums up their view
of the source of competitive advantage: ‘People—Service—Profit’. Fred
Smith, founder and CEO of the firm, says, ‘We discovered a long time
ago that customer satisfaction really begins with employee satisfaction’
(Waterman 1994). In other words, the FedEx philosophy is that people are
the primary link in the value chain, and thus, value is created by focusing
first on employees.
How is this operationalized to create value? This emphasis on employee
satisfaction is illustrated by FedEx’s annual attitude survey. Most organi-
zations administer attitude surveys from time to time, and occasionally
use the information gleaned from the surveys to address the most glaring
organizational problems. At FedEx, however, the attitude survey forms
part of the annual managerial evaluation and reward process. The survey
addresses the atmosphere of an individual’s immediate work group, the
immediate manager, the managers at levels higher in the organization, and
the company’s atmosphere in general. Scores on the items covering the
work group and the immediate manager form ‘the leadership index’. This
index is used in two ways. If an individual manager receives low scores
on the index from the employees reporting to him or her, that manager
faces a year-long probation. During that time the manager is expected to
improve the scores to an acceptable level or face some type of punitive
action. Second, each year a goal is set for the company’s score on the
leadership index. If the goal is not met, the top 300 managers in the firm do
not receive any bonus, which usually is about 40 percent of base salary. By
linking rewards and punishment to employee satisfaction levels, the firm
ensures that employees are treated well. When they are treated well, they
treat customers well—and this creates value.
124 RBT AND ORGANIZATIONAL CAPABILITIES

FedEx’s philosophy has gained an increasing base of empirical support.


For example, Schneider and Bowen (1985) hypothesized that HR prac-
tices would be related to employee attitudes which would consequently
be related to customer satisfaction. They found significant relationships
between HR practices and customer reports of the quality of service they
received in a sample of banks. Schlesinger and Zornitsky (1991) found that
job satisfaction predicted employees’ perceptions of service quality as well
as the discrepancy between employee and customer perceptions of quality.
Ulrich et al. (1991) found significant relationships between the tenure of
employees and customer satisfaction. Tornow and Wiley (1991) found
that employee attitudes such as job satisfaction were related to measures
of organizational performance. In addition, Schmit and Allscheid (1995)
found that employees’ climate perceptions of management, supervisor,
monetary, and service support were related to employee affect. Affect was
related to service intentions, which was related to customer service. Empir-
ical research thus supports the notions that employee satisfaction is linked
to service quality and that HR practices are important determinants of
employee satisfaction.
Finally, some HR practices can impact on both costs and revenues.
Continental Airlines experienced a tremendous turnaround in which the
HR function played a vital role. One of the frequently cited HR practices
responsible for this turnaround was the on-time bonus, an incentive system
in which each employee was paid a bonus of $65 for every month the airline
was at the top of the industry in on-time performance (Boissueau 1995).
While this may seem like it comes straight from any introductory textbook
(Barlow 1996), its origin was not nearly so simple. In early 1995, after years
of pay cuts or no pay raises, top management discovered that it again would
be unable to give pay raises to employees. HR executives recognized that
taking that message to the employees at a critical phase of the turnaround
would destroy morale and greatly impede the cultural shift under way. HR
executives along with line executives came up with the idea of the on-time
bonus. This bonus resulted in Continental moving from last to first in the
industry in on-time performance and consequently both decreased costs
and increased revenues. On the cost side, the company paid out $51 million
in bonuses in the next year but saved $75 million in lower passenger
accommodation costs such as money for meals and hotel rooms associated
with missed connections. On the revenue side, the bonus was instrumental
HUMAN RESOURCES 125

in restoring employee morale and, thus, increasing customer satisfaction.


In addition, because on-time performance is an important criterion for
the higher revenue business traveler, this bonus had a strong impact on
the firm’s revenues as they increased their share of the business traveler
market.

RARITY OF HUMAN RESOURCES


The value of a firm’s human resources is a necessary but not sufficient
criterion for competitive advantage. If the same characteristic of human
resources is found in many competing firms, then that characteristic can-
not be a source of competitive advantage for any one of them. Valuable
but common characteristics of human resources provide only competitive
parity, ensuring that a firm is not at a substantial competitive disadvantage
because it does not possess that characteristic. Thus, an HR executive
must examine how to develop and exploit rare characteristics of the firm’s
human resources to gain competitive advantage.
For example, most firms view the labor pool for particular jobs as rel-
atively homogeneous. Within any labor pool, however, differences exist
across individuals in terms of their job-related skills and abilities. If the
assumption exists across firms that the labor pool is homogeneous, there
can be tremendous potential to exploit the rare characteristics of those
employees for competitive advantage (Wright, McMahan, and McWilliams
1994).
For example, Nordstrom’s exists in the highly competitive retailing
industry. This industry is usually characterized as having relatively low-skill
requirements and high turnover for sales clerks. Nordstrom’s, however, has
attempted to focus on individual salespersons as the key to its competitive
advantage. It invests in attracting and retaining young, college-educated
sales clerks who desire a career in retailing. It provides a highly incentive-
based compensation system that allows Nordstrom’s salespersons to make
as much as twice the industry average in pay. The Nordstrom’s culture
encourages sales clerks to make heroic efforts to attend to customers’ needs,
even to the point of changing a customer’s flat tire in the parking lot.
The recruiting process, compensation practices, and culture at Nordstrom’s
have helped the organization to maintain the highest sales per square foot
126 RBT AND ORGANIZATIONAL CAPABILITIES

of any retailer in the nation. Nordstrom’s has taken what is considered to be


a relatively homogeneous labor pool and exploited the rare characteristics
of its employees to gain a competitive advantage.

IMITABILITY OF HUMAN RESOURCES


Valuable and rare characteristics of a firm’s human resources can pro-
vide above-normal profits for the firm in the short term; however, if
other firms can imitate these characteristics, then over time the char-
acteristics will provide no more than competitive parity. The HR exec-
utive must attempt to develop and nurture characteristics of the firm’s
human resources that cannot easily be imitated by competitors. This
points to focusing on the importance of socially complex phenomena such
as an organization’s unique history or culture in providing competitive
advantage.
Every firm has a unique history that shapes and defines the present situ-
ation. This history often provides a foundation for a competitive advantage
which other firms find difficult or impossible to imitate. For example,
a high-level executive at one of DuPont’s competitors observed that no
matter what his firm did (including purchasing DuPont’s safety training
programs), they were unable to match DuPont’s safety record. When asked
to explain why, he stated: ‘When a firm starts out by making dynamite,
something happens that just instils in employees’ minds the importance
of safety.’ Thus, DuPont’s superior safety performance stems at least in
part from its unique history that competitors would find impossible to
imitate.
Southwest Airlines exemplifies the role that socially complex phenomena
such as culture play in competitive advantage. According to the company’s
top management, the firm’s success can be attributed to the ‘personality’
of the company; a culture of fun and trust that provides employees with
both the desire and the discretion to do whatever it takes to meet the
customers’ needs. The ‘fun’ airline uses an extensive selection process for
hiring flight attendants who will project the fun image of the airline.
Applicants must go through a casting call type exercise where they are
interviewed by a panel that includes current flight attendants, managers,
and customers. The applicants tell stories, such as their most embarrassing
HUMAN RESOURCES 127

experience, in front of the panel and other applicants. Those who make
it through the panel interview are then examined against a psychological
profile that distinguished outstanding past flight attendants from those
who were mediocre or worse.
In addition to the extensive selection process, employees are empow-
ered to create an entertaining traveling environment by a strong orga-
nizational culture that values customer satisfaction. Says Herb Kelleher,
CEO:
We tell our people that we value inconsistency. By that I mean that we’re
going to carry 20 million passengers this year and that I can’t foresee all of
the situations that will arise at the stations across our system. So what we tell
our people is, ‘Hey, we can’t anticipate all of these things, you handle them the
best way possible. You make a judgment and use your discretion; we trust you’ll
do the right thing. If we think you’ve done some thing erroneous, we’ll let you
know—without criticism, without backbiting.’ (Quick 1992)

This extensive selection process and the strong organizational culture


contribute to the differentiated service that has made Southwest Airlines
the most financially successful airline over the past twenty years and has
enabled it to continually be among the best in the industry for having the
fewest customer complaints.
Seeing this financial success, competitors, such as Continental Airlines
(Continental Lite) and United Airlines (United Express), attempted to
compete with Southwest Airlines by providing low-cost service to a num-
ber of destinations. Continental Lite ceased operations within a year, and
United, while having survived, is still losing to Southwest in most mar-
kets where they compete. Kelleher, who believes that Southwest’s superior
performance has happened because its culture simply cannot be imitated,
stated:
Maybe someone could equal the cost . . . possibly they could. And maybe some-
one could equal the quality of service that goes along with that and consti-
tutes great value, . . . possibly they could. But the one thing they would find it
impossible to equal very easily is the spirit of our people and the attitude they
manifest toward our customers. (Quick 1992)

In other words, the human resources of Southwest Airlines serve as a source


of sustained competitive advantage because they create value, are rare, and
are virtually impossible to imitate.
128 RBT AND ORGANIZATIONAL CAPABILITIES

THE ORGANIZATION OF HUMAN RESOURCES


Finally, in order for any characteristic of a firm’s human resources to
provide a source of sustained competitive advantage, the firm must be
organized to exploit the resource. Organization requires having in place
the systems and practices that allow HR characteristics to bear the fruit of
their potential advantages.
For example, both General Motors (GM) and Ford historically have
recruited assembly line workers from the same basic labor market. There is
little evidence that the skill levels of Ford’s workers are significantly higher
than those of GM workers. Ford, however, has been more successful at
developing a cooperative, team-based culture than has GM. Both automak-
ers set out to develop employee involvement programs during the late
1970s and early 1980s. Ford more successfully changed the culture and HR
systems to allow for, and even value, employee participation in decision-
making, relative to GM. Ford’s culture and HR systems allow for employees
to participate in decision-making and to utilize cognitive skills that the
GM systems have been less able to exploit (Templin 1992). In addition,
as Ford moves toward hiring even more highly skilled employees through
an extensive assessment process, its participative system will leave it poised
to increase its relative advantages over GM (Templin 1994).
The question of organization focuses attention on systems, as opposed
to single HR practices. Research on HR practices and firm performance
seems to indicate that HR practices are most effective when they exist as
a coherent system. Wright and Snell (1991) argued that Strategic Human
Resource Management (HRM) required coordinated HR activities across
the various subfunctions. Similarly, Wright and McMahan’s definition
(1992) of Strategic HRM called for ‘horizontal integration’ of the vari-
ous HR practices rather than viewing each in isolation. Lado and Wilson
(1994) hypothesized that the more complex the HR system, the more likely
it would be to serve as a source of sustainable competitive advantage.
MacDuffie (1995), in a study of automobile manufacturing firms, found
that performance was maximized when ‘bundles’ of HR practices were
linked with participative work systems and flexible production systems.
Wright et al. (1996) found that HR practices such as selection, appraisal,
and compensation were unrelated to the financial performance of petro-
chemical refineries alone, but that they were strongly positively related to
performance among refineries that had highly participative work systems.
HUMAN RESOURCES 129

These research studies seem to indicate a need for HR functions to pay


attention to the system of HR practices, rather than to focus on each in
isolation.
Both quantitative and qualitative data gathered from an ongoing
research study indicate that very few companies are spending much time
and attention on coordinating each of the various HR subfunctions (e.g.
staffing, compensation, training, and so on) with one another.1 Of thirteen
firms in this study, only two have actively attended to achieving integration
among the compensation, selection, training, and appraisal systems and
processes. It appears that firms that do make such efforts have at least
temporary advantages over their competitors.

Human resources and sustainable


competitive advantage

The VRIO analysis above illustrates how a variety of firms have attempted
to develop their human resources to provide sources of sustainable com-
petitive advantage. The VRIO framework (summarized in Table 3.1) pro-
vides a tool to assist managers to evaluate the potential for specific firm
resources to be sources of competitive disadvantage, competitive parity,
competitive advantage, and sustained competitive advantage. According to
this framework, aspects of human resources that do not provide value can
only be a source of competitive disadvantage. These resources or activities
are ones that HR executives should be discarding from the HR function.
Aspects of human resources that provide value, but are not rare, are sources
of competitive parity. These resources are not to be dismissed; not to have
them is a source of competitive disadvantage, but because other firms
possess them, they cannot provide an advantage in the competitive arena.
Temporary competitive advantage stems from resources that provide value
and are rare, but are easily imitated. If these resources do serve as a source of
competitive advantage, then other firms will soon imitate them, resulting
in competitive parity. Finally, aspects of human resources that are valu-
able, rare, and not easily imitated can be sources of sustained competitive
advantage, but only if the firm is organized to capitalize on these resources.
Clearly the HR function, through either directly controlling or strongly
influencing the characteristics of human resources in organizations, plays
130 RBT AND ORGANIZATIONAL CAPABILITIES

an important role in developing and maintaining a firm’s competitive


advantage. Simply making the case that HR can influence a firm’s perfor-
mance, however, is only part of the story. In order for HR to truly develop
and maintain sources of competitive advantage, HR executives need to
focus attention and activities toward those aspects of the firm’s resources
that will provide such advantages.
Now, the potential of several types of human resources to be sources of
sustained competitive advantage is examined: firm-specific versus general
skills, teams versus individuals, and HR systems versus single HR practices.

FIRM-SPECIFIC VERSUS GENERAL SKILLS


Human capital theory (Flamholtz and Lacey 1981) distinguished between
general skills and firm-specific skills of human resources. General skills
are skills possessed by individuals that provide value to a firm and are
transferable across a variety of firms. For example, all competitor firms
have the potential to accrue equal value from acquiring employees with
knowledge of general management, the ability to apply financial ratios, or
general cognitive ability. Specific skills, on the other hand, provide value
only to a particular firm and are of no value to competing firms. For
example, the knowledge of how to use a particular technology used only by
one firm, or knowledge of a firm’s policies and procedures provide value to
that firm but usually would not be valuable to other firms.
Because general skills provide equal value to all firms, one would expect
that, given even moderately efficient labor markets, these would not be a
source of competitive advantage for any one organization; thus, to seek
to gain sustained competitive advantage through general skills would be
futile. On the other hand, there are two reasons that this does not imply
that these skills are not important. First, general skills are necessary for
maintaining competitive parity. For example, basic reading and writing
skills are general skills that will not provide competitive advantage to
any one firm; however, a firm that hired many employees who could not
read and write would be at considerable disadvantage in the marketplace.
Second, most organizations have defined the ‘New Deal’ between the
firm and its employees. This new psychological contract (Rousseau and
Greller 1994) is characterized by employers assuring that they will not
HUMAN RESOURCES 131

guarantee employment but will guarantee employability to people (Kissler


1994). This requires providing employees with the necessary training and
development that ensures them marketability to other firms (i.e. general
skills). Firms that fail to invest in general skills will be unable to attract and
retain competent employees.
In addition, while general skills are applicable across organizations and
thus most likely to result in only competitive parity, this does not preclude
gaining competitive advantage through obtaining the highest level of gen-
eral skills. For example, Wright et al. (1994) argued that firms that were
able to obtain the highest level of average cognitive ability would have a
competitive (and possibly sustainable) advantage. We would not argue for
ignoring the importance of general skills; they add value and at the highest
level are rare.
Greater potential for sustainable competitive advantage stems from
investments in firm-specific skills. One avenue to sustained competitive
advantage is to focus on developing a firm-specific skill base within an
organization, because these skills cannot be easily duplicated by com-
petitors. These skills provide value to the firm, but they are not eas-
ily marketable by the employees who possess them. One can accom-
plish this through investing in constant training and development of
employees to perform work processes and procedures that are specific to
the firm (Hatch and Dyer 2004). In fact, central to the concept of orga-
nizational learning is the process of developing and disseminating tacit
knowledge (i.e. firm-specific knowledge) throughout the firm (Senge 1990;
Miller 1996). The firm gathers the rents accruing from these firm-specific
skills, while providing employees with the opportunity for growth and
development.
The importance of firm-specific skills highlights the potential short-
sightedness of outsourcing most, or all, of a firm’s training and develop-
ment activities. Outsourced activities such as these most effectively provide
general rather than firm-specific skills. While some training firms may
be able to develop tailor-made programs for specific firms, these are not
feasible when proprietary technologies and processes exist. In addition,
the training firm that develops the tailor-made programs also acquires
the skills, and can theoretically (although not ethically and possibly not
legally) exploit them with competing firms. For these reasons, while some
training activities can and should be outsourced, outsourcing of all training
132 RBT AND ORGANIZATIONAL CAPABILITIES

activities is not likely to serve as the lever for gaining sustainable competi-
tive advantage through people.

TEAMS VERSUS INDIVIDUALS


Much of the popular literature on top management seems to point to
individual CEOs, such as Lee Iaccoca at Chrysler, Jack Welch at General
Electric, or Lawrence Bossidy at AlliedSignal, as sources of sustainable
competitive advantage. Similarly, much of the academic work on matching
human resources to organizational strategies has focused on top managers
and ignored the lower-level employees (Gerstein and Reisman 1983; Gupta
and Govindarajan 1984; Guthrie, Grimm, and Smith 1991). The inher-
ent assumption in this research is that the skills of the workforce are all
common across firms, but that highly skilled individual managers or top
management teams are more rare (Wright et al. 1994). This implies that the
firm with the right CEO or president might possess a source of sustained
competitive advantage. While these individuals are quite valuable, if labor
markets are at all efficient, they are not likely to be a source of sustained
competitive advantage.
Individuals who possess valuable and rare skills are usually able to claim
most of the rents that are attributable to those skills (Wright et al. 1994).
An outstanding chief executive, because of the high visibility of his/her
performance, will soon be approached by other organizations with higher
compensation. In the bidding process for that individual’s services she or
he can claim most of the rents, and, therefore, the rents will not accrue to
whichever firm ultimately obtains that individual’s services.
Numerous shifts of top managers from one firm to another (e.g.
Gerstner to IBM), as well as the rapidly rising top executive pay, exemplify
the futility of seeking sustainable competitive advantage from the skills of
one individual. On the other hand, the exploitation of the synergistic value
from a large number of individuals who work together is quite costly, if
not impossible, for competitors to imitate. Teams or larger groups, due to
causal ambiguity and social complexity, provide greater potential to be a
source of sustainable competitive advantage.
Alchian and Demsetz (1972) defined team production as ‘production
in which (1) several types of resources are used, and (2) the product is
HUMAN RESOURCES 133

not a sum of the separable outputs of each cooperating resource’ (p. 779).
Because output is more than the sum of the separable outputs of each
cooperating resource, it is difficult, if not impossible, to identify the spe-
cific source of the competitive advantage. In other words, the competitive
advantage stemming from team production is characterized as being
causally ambiguous, thus making it difficult for competitors to imitate.
An additional benefit of team production is that individuals become
linked in transaction-specific relationships, resulting in transaction-
specific human capital. In other words, team members become involved
in socially complex relationships that are not transferable across organi-
zations, thus only benefiting the organization in which these relationships
develop. This nontransferability requires the development of a team ori-
entation, as has been exemplified among the top managers at Continental
Airlines. One part of its turnaround was the replacement of thirty-six of the
company’s top officers within a twelve-month time frame. CEO Gordon
Bethune states, ‘Why do you think most of those VPs disappeared? Most of
them could not be team players.’ This has resulted in a reorientation among
the top managers at Continental to focus on team goals, instead of being
strictly focused on their own personal goals (Boissueau 1995).
This highlights the importance of the HR function in developing and
nurturing the relationships among organizational members. Many tradi-
tional organizational development activities, such as team building and
conflict resolution, are included in the HR activities of Fortune 500 com-
panies (McMahan and Woodman 1992; Kotter and Cohen 2002; Beitler
2003). In addition, researchers are beginning to explore trust among orga-
nization members as one determinant of firm performance (Gambetta
1988; Barney and Hansen 1994; Mishra and Mishra 1994). Clearly trust
(see Chapter 5) and good relationships among organizational members
are firm-specific assets that provide value, are quite rare, and are extremely
difficult for competitors to imitate.

HR SYSTEMS VERSUS SINGLE HR PRACTICES


Much of the writing on Strategic HRM has focused on HR practices as
a source of competitive advantage (Schuler and MacMillan 1984). The
assumption is that firms that engage in the best HR practices, that is,
134 RBT AND ORGANIZATIONAL CAPABILITIES

have the best selection system, or best training program, or best reward
system, etc., will have a competitive advantage over firms that fail to use
this particular practice. Both the work on utility analysis of HR programs
(Cascio 1987; Steffy and Maurer 1988; Boudreau 1991; Jones and Wright
1992) and empirical work on the relationship between HR practices and
performance (e.g. Terpstra and Rozzell 1993) have demonstrated that HR
practices do provide value to the firm.
While each of these practices provides value, VRIO analysis suggests that
they are not likely to be sources of sustained competitive advantage. Given
the emphasis on benchmarking to identify the most effective HR practices,
any individual effective practice is easily imitated, and thus, can provide an
advantage only for a short time—until competitors can copy it.
The fact that these individual practices will not likely lead to sustainable
competitive advantage does not imply that these practices are unimportant
and HR executives can ignore identifying the best practice for each of the
various HR activities. The failure to invest in state-of-the-art selection,
training, and reward systems can result in a firm having a competitive
disadvantage among human resources. In addition, a series of temporary
competitive advantages gained through constant innovation is still quite
valuable to the firm.
The challenge for HR is to develop systems of HR practices that create a
synergistic effect, rather than developing a set of independent best practices
of HR (Wright and Snell 1991; Lado and Wilson 1994; Becker and Gerhart
1996). This requires a changing mindset from the traditional subfunc-
tional (selection, training, appraisal, compensation, etc.) view of HR to
one where all of these independent subfunctions are viewed as interrelated
components of a highly interdependent system. The interrelatedness of the
system components makes the advantage difficult, if not impossible, for
competitors to identify and copy. It also requires investing time and energy
into developing systems and structures for integrating various HR prac-
tices such that they complement, rather than conflict with, one another.
While this sounds quite commonsensical, conversations with a number of
HR executives consistently indicate that very few HR departments have
developed any such systems and structures. Firms that have developed
highly integrated systems seem to have obtained a source of sustainable
competitive advantage. Research on bundles of HR practices supports this
notion (MacDuffie 1995; Delery and Doty 1996; Youndt et al. 1996).
HUMAN RESOURCES 135

The implications of this resource-based analysis using the VRIO frame-


work appear contrary to much of the management thinking that empha-
sizes the importance of finding the right CEO, outsourcing HR functions,
or seeking sustained competitive advantage through finding one best HR
practice. The analysis does not imply that these activities are not valuable,
but only that they are incomplete, particularly in guiding the decision-
making of HR executives. The following section examines implications of
resource-based analysis for HR executives.

Implications for HR executives

This resource-based analysis has a number of implications for HR execu-


tives. In general, it highlights the fact that HR executives play an important
role in managing the firm’s human assets, those that possess the great-
est potential for being sources of sustained competitive advantage. More
specifically, it provides guidance regarding the management of the HR
function in organizations in ways that will create competitive advantage.
Four of these major implications are outlined below, with questions to help
guide the HR executive in managing the function.
1. The value of people and their role in competitive advantage. Knowing
the economic value of the firm’s human resources is a necessary precon-
dition before any HR executive can begin to manage the function strate-
gically. Reichheld (1996) notes that people contribute to firms in terms of
efficiency, customer selection, customer retention, customer referral, and
employee referral. People play an important role in the success of any firm,
but which people do so, and how they contribute, may vary across firms.
This knowledge is a necessary starting point for any HR executive to act as
a strategic partner.
For example, research indicates that firms that rely heavily on innova-
tion and product development (e.g. Merck) argue that their research and
development (R&D) scientists’ ability to develop successful new products
is the major thing that distinguishes those companies from competitors.
Manufacturing firms such as Dell Computer, on the other hand, emphasize
the production efficiency advantages they can gain through harnessing
all of their peoples’ skills and effort. Finally, service-oriented firms, such
as Continental Airlines, note that the planes, routes, gates, and fares are
136 RBT AND ORGANIZATIONAL CAPABILITIES

virtually identical within the industry. Their competitive advantage can


only come through efficient, friendly service that makes fliers want to make
their next flight on Continental.
Similarly, while all of the firm’s people are important, some provide
greater leverage for competitive advantage. Because of the need for inno-
vation, Merck’s R&D scientists provide greater leverage for success than do
the hourly manufacturing employees. On the other hand, it is the hourly
line employees (ticket agents, flight attendants, gate crews, and baggage
handlers) who directly impact the flying experience that have a relatively
stronger impact on competitive advantage for Continental Airlines.
Thus, HR executives must first understand the role of the firm’s people
in competitive advantage before being able to make decisions about how
to position the deliverables of the function. This leads to the following
questions for these executives:
r On what basis is the firm seeking to distinguish itself from competi-
tors? Production efficiency? Innovation? Customer service?
r Where in the value chain is the greatest leverage for achieving this
differentiation?
r Which employees or employee groups provide the greatest potential
to differentiate a firm from its competitors?
2. The economic consequences of HR practices. Once an HR executive
understands the specific ways in which the firm’s people provide value, it is
necessary to examine the value that HR provides or can provide. Research
has uncovered a relationship between HR practices and the financial per-
formance of firms (Huselid 1995; MacDuffie 1995; Youndt et al. 1996).
While this research is promising, more research is needed on how, exactly,
this impact is gained. At least two possibilities exist.
First, HR practices may be important levers by which firms develop
human capital and employee commitment. It is the HR practices that can
directly impact the skills of the workforce that can provide value to the
firm. These practices also can help to develop committed employees who
are willing to allocate their discretionary behavior toward organizational
ends (MacDuffie 1995; Wright et al. 1996). In other words, HR practices
play an important role in developing the human assets that provide com-
petitive advantage.
It is also important to understand that HR practices and the HR function
incur costs for organizations. HR can impact firm performance through its
HUMAN RESOURCES 137

efficiency in developing the human assets that are a source of competitive


advantage (Ulrich 1997). The products and services provided by the HR
function can be too many or too few, of high quality or of low quality,
directly linked to business needs or unrelated to the business. For example,
HR practices developed because they are the latest fad, without a careful
analysis of their ability to meet strategic business needs, are both excessive
and inefficient. Similarly, the failure to develop practices that will help
address business needs results in less than optimal organizational effec-
tiveness. Finally, HR practices designed to meet business needs that are
delivered at excessive cost or with low quality negatively impact the firm’s
financial performance. HR executives need to assess both the menu of HR
practices and services offered, as well as the quality and efficiency in their
delivery.
As part of Continental Airlines’ turnaround, for example, the HR func-
tion took a long look at the services it provided and how efficiently those
services were provided. The result of this analysis was the elimination
and consolidation of a number of training programs that simply were
unrelated to the business while keeping some of the remaining training
programs internal to the firm, the outsourcing of benefits and some train-
ing/development activities, and the development of a variety of variable
pay plans (the on-time bonus, management bonus plans, profit sharing,
etc.). The firm has continued exploring further outsourcing and strategic
partnerships as ways to reduce the costs of the function. Finally, in an effort
to remain close to its customers, the HR function surveyed the company’s
officers regarding the importance of the services provided by HR as well as
HR’s effectiveness at delivering those services. This effort will identify areas
for further improvement.
HR executives seeking to explore the value created by their functions
need to ask the following questions:

r Who are your internal customers and how well do you know their part
of the business?
r Are there organizational policies and practices that make it difficult
for your internal clients to be successful?
r What services do you provide? What services should you provide?
What services should you not provide?
r How do those services reduce internal customers’ costs or increase
their revenues?
138 RBT AND ORGANIZATIONAL CAPABILITIES

r Can those services be provided more efficiently by outside vendors?


r Can you provide those services more efficiently?
r Do managers in the HR function understand the economic conse-
quences of their jobs?

3. Comparison of HR practices with competing firms. The previous two


points focus on the HR executive’s attention within the organization. In
a competitive environment, however, one cannot ignore the actions of
competitors, and this is also true of HR. It is necessary to examine the HR
functions of competitors to gain an understanding of what HR practices
and relationships define the present competition. This information is only
valuable insofar as it is used for developing strategies for changing the
competitive landscape to a firm’s advantage.
Such benchmarking activity has become almost commonplace in indus-
try as firms look both within and outside their industries seeking the ‘best
practices’. Benchmarking provides information that can be valuable or
useless, depending upon how it is used. If the goal of the activity is simply
to identify the HR practices of successful firms in order to imitate them,
then the costs will likely outweigh the benefits. Benchmarking identifies
the rules of competition in an industry and can be particularly valuable in
providing information on two issues.
First, it helps firms to identify what superior practices the competition is
engaged in which might provide them with a competitive advantage until
other firms are able to imitate it. For example, Nieman Marcus, the upscale
retailer, implemented a sophisticated applicant tracking system that sig-
nificantly reduced its recruiting costs. Because the system was purchased
from an outside vendor, it did not take long for competitors to imitate
the advantage through implementing similar systems. Had competitors not
identified the system as an advantage, however, their financial performance
might have suffered needlessly.
Second, benchmarking should be used to identify ways to leapfrog com-
petitors. This is accomplished through developing innovative HR practices
and is especially successful if they are ones that competitors will find it
costly or difficult to imitate. For example, one of Merck’s manufacturing
plants shifted to a variable pay system resembling a gain-sharing type plan.
This plan has been hugely successful even while other plants in the industry
and geographic area have been disbanding such plans. Why did it work at
HUMAN RESOURCES 139

Merck? Merck’s manufacturing managers attribute the success to the fact


that the company has traditionally had a culture that is characterized by
high levels of trust between employees and management. The compensa-
tion system, while imitable in formulas, structures, and procedures, was
not imitable in practice since its success was contingent on Merck’s unique
history and culture.
HR executives need to understand their functions in relationship to
competitors as a means of identifying which practices should be copied to
maintain competitive parity, which practices can be innovatively delivered
to provide temporary advantage, or which practices can be linked to the
unique situation (culture, history, other management systems, etc.) of the
firm in order to gain sustainable competitive advantage. This understand-
ing leads to the following questions for HR executives:
r How do the workforce skills of your competitors (particularly in key
jobs) compare to those in your firm?
r How does the commitment level of your workforce compare to that of
competitors?
r What are your competitors’ HR functions doing in terms of practices
and relationships with line managers? How can you beat them by
doing things better or differently?
r What unique aspects of your firm (e.g. history leadership, culture, and
so on) might allow you to develop and/or maintain a more highly
skilled and highly committed workforce?
r What HR practices need to be developed or maintained to exploit
these unique aspects of your firm?
r Given your firm’s history and culture, what unique HR practices might
you be able to implement more efficiently and effectively than your
competitors?
4. The role of the Human Resources function in building organizational
capability. A constant tension exists in the trade-offs between focusing
decision-making and resource allocation on the short-term and long-term
in most organizations. This conflict also exists within the HR function.
Many HR functions are struggling so hard to meet current needs that they
have little time to explore long-term organizational plans. This tendency
must be broken if HR executives want to play the role of strategic partner.
140 RBT AND ORGANIZATIONAL CAPABILITIES

For example, a high-tech manufacturing firm has seen tremendous


growth in both revenues and headcount over a four-year period. This
growth resulted in the HR function struggling to keep up with the hiring
and training needs of a firm growing by 40 percent per year. Such growth
also made it difficult for the HR function to pay attention to developing the
organizational infrastructure necessary to maintain the growth. During the
last two years, the HR function in this firm began investing in developing
organizational capability through the creation of a succession and devel-
opmental planning system for the management team and a HR planning
system for the rest of the organization. Without such an investment, the
firm’s growth prospects would have been substantially limited.
In spite of the need to deliver the traditional HR services to meet the
organization’s current needs, HR executives must consider the future orga-
nization’s needs by answering the following questions:
r Which of the firm’s resources and capabilities provide temporary or
sustainable competitive advantage now? Five years from now? Ten
years from now?
r What will be the competitive landscape 5–10 years from now in terms
of your firm’s product markets and labor markets?
r What kind of human resources will your firm need to compete suc-
cessfully five years from now? Ten years from now?
r What types of HR practices are needed today to build the organization
needed in the future?

Conclusion

This resource-based analysis of human resources has shown that HR exec-


utives have a key role in nurturing, developing, and managing the set of
HR resources (e.g. human capital skills, employee commitment, culture,
teamwork, and so on) that are most likely to be sources of sustained
competitive advantage for their organizations. The HR function can also
adopt a strategic focus, applying the VRIO framework to identify specific
HR resources that provide sources of temporary and/or sustainable com-
petitive advantages. Guidance for HR executives on how to create value
HUMAN RESOURCES 141

from the HR function and act as a partner for the company’s strategists has
been outlined.
The VRIO framework helps the HR executive to evaluate all of the activ-
ities of the function against the criteria of value, rareness, imitability, and
organizational exploitation. As discussed, HR activities that are valuable
but not rare, or valuable and rare but imitable, are not to be ignored. These
are the activities that the function must perform to maintain competitive
parity, or to provide temporary competitive advantages. For example, com-
petitor firms are likely to be able to imitate a particular HR selection system
that identifies cognitive abilities, technical skills, and/or interpersonal skills
that provide value; however, to fail to identify these skills in the selection
process can result in a severe competitive disadvantage.
The ultimate quest should be for the HR function to provide the firm
with resources that provide value, are rare, and cannot be easily imitated
by other organizations. This quest entails developing employees who are
skilled and motivated to deliver high-quality products and services, and
managing the culture of the organization to encourage teamwork and trust.
It also requires that HR functions focus more attention on developing
coherent systems of HR practices that support these aims.

NOTE

1. On going research study conducted by Patrick Wright.


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7 Information
technology as a
source of sustained
competitive
advantage∗

The field of strategic management focuses on understanding sources of


sustained competitive advantages for firms (Porter 1980, 1985; Rumelt,
Schendel, and Teece 1991). A variety of factors have been shown to have an
important impact on the ability of firms to obtain sustained competitive
advantage. Some of these have been discussed in previous chapters of this
book—including organizational culture, trust, and human resources.
Information technology (IT) has also been mentioned for its possible
role in creating sustained competitive advantages for firms (Clemons 1986,
1991; Clemons and Kimbrough 1986; Clemons and Row 1987, 1991a;
Feeny 1988; Feeny and Ives 1990; Barney 1991a; Powell and Dent-Micallef
1997; Bharadwaj 2000; Ray 2000). While the assertion that IT might be able
to create sustained competitive advantage for firms is provocative, work in
this area is relatively underdeveloped, both empirically and theoretically
(Jarvenpaa and Ives 1990; Powell and Dent-Micallef 1997). Research on
IT and competitive advantage has predominantly emphasized ‘describing
how, rather than systematically why’ IT can lead to such an advantage
(Reich and Benbasat 1990: 326). Accordingly, the IT literature contains
case studies of spectacular IT successes, but few conceptual frameworks
designed to encourage and assist IT managers with IT implementation
(Powell and Dent-Micallef 1997).
∗ This chapter draws from Mata, Fuerst, and Barney (1995) and Ray, Barney, and
Muhanna (2004).
144 RBT AND ORGANIZATIONAL CAPABILITIES

Indeed, some scholars have become quite skeptical about the potential
of IT to be a source of competitive advantage. Several empirical studies
exploring IT and performance have found that IT adoption and imple-
mentation are not necessarily linked to superior performance. For exam-
ple, ATM adoption in the banking industry was not positively correlated
with performance in studies by Banker and Kauffman (1988) and Floyd
and Woolridge (1990). Within five years of IT implementation, 70 per-
cent of the firms studied by Kettinger et al. (1994) had experienced com-
petitive declines in either market share, profits or both. The impacts of
IT on entry barriers were studied by Mahmood and Soon (1991) who
reported no discernable effects in most industries; where IT impacts were
found they tended to reduce, rather than increase, entry barriers. A recent
Harvard Business Review article suggested that IT—because it was so widely
available—was no longer strategically relevant (Carr 2003). In this view,
IT may create value firm by increasing internal and external coordinat-
ing efficiencies. Firms that do not adopt such IT will have higher cost
structures and therefore competitive disadvantages. However, firms cannot
expect IT to produce sustainable advantages because most IT is readily
available to all firms—competitors, buyers, suppliers, and potential new
entrants—in competitive factor markets (Clemons and Row 1991a; Powell
and Dent-Micallef 1997).
This chapter uses resource-based theory to evaluate the potential of IT
to be a source of competitive advantage for firms, both temporary and
sustained. After discussing how IT can create economic value, the ability
of five key attributes of IT—customer switching costs, access to capital,
proprietary technology, technical IT skills, and managerial IT skills—to
generate sustained competitive advantage is evaluated. The chapter con-
cludes by summarizing some recent empirical results on the relationship
between IT and competitive advantage (Ray, Barney, and Muhanna 2004;
Ray, Muhanna, and Barney 2005).

The value of IT

Traditionally, most research in strategic IT has focused on the ability of


IT to add economic value to a firm by either reducing a firm’s costs or
differentiating its products or services (see McFarlan 1984; Porter and
INFORMATION TECHNOLOGY 145

Millar 1985; Bakos and Treacy 1986; Wiseman 1988). For example, when
Wal-Mart adopted its purchase–inventory–distribution system, it was able
to reduce its inventory costs (Ghemawat 1986; Huey 1989; Stalk, Evans,
and Shulman 1992). On the other hand, GE was able to differentiate its
service support from its competitors by means of its call center technology
(Benjamin et al. 1984; Porter and Millar 1985), and Otis Elevator similarly
differentiated its service operations thanks to its Otisline system (McFarlan
and Stoddard 1986; Balaguer 1990). In all these cases, the judicious use of
IT either reduced these firms’ costs of operations or increased their rev-
enues by differentiating their products or services, or both, and therefore
created value for these firms.
Indeed, there is little doubt that, in a wide variety of circumstances, IT
can add value to a firm. However, as suggested earlier, IT adding value to a
firm—by reducing costs and/or increasing revenues—is not the same as IT
being a source of sustained competitive advantage for a firm. For example,
when Wal-Mart adopted its purchase–inventory–distribution system, it
gained a competitive advantage over its closest rival, K-Mart. However, K-
Mart did not remain idle and developed its own similar system (Steven
1992). With respect to this system, Wal-Mart gained only a temporary,
but not sustained, competitive advantage (Barney 1994a). Put another
way, Wal-Mart’s purchase–inventory–distribution system was valuable, but
value, per se, is a necessary but not sufficient condition for a sustained
competitive advantage.

IT and sustained competitive advantage

Five attributes of IT have been suggested as possible sources of sustained


competitive advantage in the literature. These five attributes are evaluated
here using resource-based logic.

CUSTOMER SWITCHING COSTS


At one time, it was suggested that customer switching costs could create
competitive advantages for some firms. This logic was summarized in the
‘create-capture-keep’ paradigm (Clemons and Kimbrough 1986; Clemons
146 RBT AND ORGANIZATIONAL CAPABILITIES

and Row 1987, 1991b; Feeny and Ives 1990). In this paradigm, certain
customers are forced to make supplier-specific investments in acquiring IT.
Once made, these investments make it possible for IT suppliers to appro-
priate a disproportionate share of the value created by IT—an example of
holdup as described by Williamson (1975). Firms that did not make these
specific investments, or firms that buy IT from suppliers that do not engage
in holdup, will have competitive advantages over firms that are captured by
opportunistic suppliers.
While this argument is consistent with transactions cost theory, changes
in the nature of IT over the years have made it less important for firms
to make supplier-specific investments to obtain and use IT. Without such
investments, holdup cannot occur and the results of holdup cannot benefit
some firms more than others. Indeed, even in those areas of IT where spe-
cific investments are still required—such as in enterprisewide systems sold
by firms like PeopleSoft—increasingly sophisticated contracts seem to have
reduced the threat of opportunism in these exchanges. Moreover, these
contracting skills are available to most firms (Mayer and Argyres 2004).
All of this suggests that supplier-specific investments are unlikely to be a
source of competitive advantage for firms in the acquisition and use of IT.

ACCESS TO CAPITAL
The capital needed to develop and apply IT—whether in the form of
debt, equity, or from retained earnings—has been suggested as a source of
sustainable competitive advantage for at least some firms (McFarlan 1984).
The logic underlying this assertion is straightforward. First, IT investments
can be very risky, and thus the capital needed to make these investments
can be very costly. Second, IT investments can require huge amounts of
this risky capital. It may often be the case that only a few firms competing
in a particular product market will have the financial capability needed to
acquire the necessary capital to make certain IT investments. Thus, the few
firms that are able to acquire the needed capital to make these investments
can gain a sustained competitive advantage from them.
Two kinds of uncertainty can be considered as the major sources of
risk in IT investments, and are, therefore, determinants of the cost of
capital required to make those investments: technological uncertainty and
INFORMATION TECHNOLOGY 147

market uncertainty. Technological uncertainty reflects the risk that an IT


investment may not meet its expected performance targets in a timely way.
Specific sources of technological uncertainty in IT investments include
(McFarlan 1981): (a) failure to obtain the anticipated IT results because
of implementation difficulties, (b) higher than anticipated implementa-
tion costs, (c) longer than anticipated implementation time, (d) technical
performance below what was anticipated at the outset of the investment,
and (e) incompatibility of the developed IT with selected hardware and
software.1
When they were first developed, airline reservation systems were char-
acterized by high levels of technological uncertainty. Their development
required the solution of a number of unforseen problems, which reflected
the technological limitations and scarce experience available at the time.
These problems were solved in part by IBM’s direct involvement and
commitment in the development of these systems (see Copeland and
McKenney 1988, for details).
Market uncertainty, on the other hand, reflects risks related to the cus-
tomer’s acceptance of new IT products or services. Market uncertainty
was a major cause of failure for the Pronto and ZapMail systems. Even
though these systems met their technical objectives, they were not adopted
by customers. The Pronto system, an early foray into electronic banking,
did not attract enough customers in six years to break even and had to
be abandoned (Gunther 1988; Clemons and Weber 1990). Similarly, low-
cost substitutes led to the failure of Federal Express’s ZapMail, a system
designed to transmit facsimile documents through a nationwide network
(Keller and Wilson 1986; Wiseman 1988).
Of course, not all IT investments are large, nor are they all risky. If IT
investments are not large and risky, then it is likely that many firms will
have access to the capital necessary to make them. In this context, access
to capital is not likely to be a source of sustained competitive advantage.
On the other hand, some IT investments may be both large and very
risky. However, even in this context, access to capital for IT investments,
per se, is not likely to be a source of sustained competitive advantage for
firms. Consider, for example, several firms with identical IT resources and
capabilities seeking capital to make particular IT investments. While these
investments may be both risky and large, and because these firms are about
equally skilled in making IT investments, the risks of these investments are
148 RBT AND ORGANIZATIONAL CAPABILITIES

not heterogeneously distributed across these firms. According to resource-


based theory, firm attributes that are not heterogeneously distributed
across firms will only be a source of competitive parity. While the capital
used by these firms to make these IT investments will be risky and large,
it will not be any more so to any one of these firms than it is to the others
(Barney 1986a). Furthermore, technological or market uncertainty is
usually resolved once a first mover has been able to successfully implement
a system. Therefore, these risks actually affect first movers more than
followers (Lieberman and Montgomery 1988), and consequently, in many
circumstances, technology followers can have access to lower cost of capital
than technology first movers.
Of course, this simple example makes the strong assumption that com-
peting firms have the same resources and capabilities in making IT invest-
ments. Obviously, this will often not be the case. Different firms may be
differentially skilled in managing the technical and market risks associated
with particular kinds of IT investments. Put another way, firms that are
more skilled in managing their IT investments face fewer technical and
market risks than less skilled firms. These more skilled firms will have
access to lower cost of capital than less skilled firms and will be able to pur-
sue IT investments that are not available to less skilled firms. Consequently,
some firms may gain competitive advantages over other firms through their
IT investments.
However, in this situation it is inappropriate to conclude that access to
capital, per se, is a source of competitive advantage. Rather, it is the special
resources and capabilities of some firms that enable them to manage the
technical and market risks more efficiently, and allows them to gain an
advantage. If these resources and capabilities are valuable (which in this
case, they are) and heterogeneously distributed across competing firms
(again in this case, they are), they can be a source of at least a temporary
competitive advantage. Whether the skills needed to manage technical
and market risks are imperfectly mobile (i.e. whether they reflect a firm’s
unique history, are causally ambiguous, or socially complex) and thus
sources of sustained competitive advantage, is discussed in later sections
of this chapter.
Even small firms, with apparently small debt capacity and few retained
earnings, can overcome capital market disadvantages if they have access to
the required IT investment resources and capabilities. These small firms
INFORMATION TECHNOLOGY 149

can cooperate in their IT investments, gaining access to both the needed


skills and the required capital (Cash and Konsynski 1985; Vitale 1986;
Clemons and Knez 1988; Clemons and Row 1992). For example, such
cooperative efforts were used in the development of the European airline
reservation systems, Amadeus and Galileo, to overcome the problems of
a single firm acquiring large amounts of capital needed to develop such
systems (Etheridge 1988).

PROPRIETARY TECHNOLOGY
Technology that can be kept proprietary has also been suggested as a source
of sustained competitive advantage (Bain 1956; Porter 1980). Although
proprietary technology can be protected through patents or secrecy (Porter
1980), IT applications are difficult to patent (Jakes and Yoches 1989).
Moreover, even if they could be patented, there is evidence that patents pro-
vide little protection against imitation (Mansfield, Schwartz, and Wagner
1981; Mansfield 1985). Thus, secrecy is the only alternative for keeping IT
proprietary.
Clearly, if a firm possesses valuable proprietary technology that it can
keep secret, then that firm will obtain a sustained competitive advantage.
The fact that the technology is proprietary suggests that it is heteroge-
neously distributed across competing firms; the fact that it is secret suggests
that it is imperfectly mobile. However, most research indicates that it is
relatively difficult to keep a firm’s proprietary technology secret, and thus,
it is unlikely that proprietary technology will be a source of sustained
competitive advantage. This is especially true for IT (Clemons and Row
1987).
A wide variety of factors act to reduce the extent to which proprietary
IT can be kept secret. Workforce mobility, reverse engineering, and for-
mal and informal technical communication all act to reduce the secrecy
surrounding proprietary technology (Lieberman and Montgomery 1988).
Thus, if one firm finds itself at a competitive disadvantage to another
because that other firm has some proprietary IT application, the disadvan-
taged firm can hire away one or more of the individuals who developed the
advantaged firm’s application; it can purchase that application and discover
its character through reverse engineering; it can discover the nature of the
150 RBT AND ORGANIZATIONAL CAPABILITIES

application through informal discussions with developers or users; or it can


read published reports about the nature of the proprietary application and
duplicate it in that way. Put another way, while a particular firm may gain
a ‘head start’ (i.e. a temporary competitive advantage) from its proprietary
IT application, competing firms are usually not disadvantaged in imitating
that technology by history, causal ambiguity, or social complexity. Thus,
that proprietary technology usually is not a source of sustained competitive
advantage.2
IT has become, to a large extent, generic and available to most firms
(Clemons and Row 1987, 1991b). Even complex systems that used to be
immune from imitation are now broadly available from numerous sources.
For example, the software used in airline reservation systems currently can
be acquired from the companies that developed them for internal purposes
(Etheridge 1988; Hopper 1990). As this diffusion of IT continues, the
ability of proprietary technology to be a source of competitive advantage—
sustained or temporary—continues to erode.

TECHNICAL IT SKILLS
A third possible source of sustained competitive advantage from IT may
be a firm’s technical IT skills (Copeland and McKenney 1988). Technical
skills refer to the know-how needed to build IT applications using the
available technology and to operate them to make products or provide
services (Capon and Glazer 1987). Examples of such technical skills might
include knowledge of programming languages, experience with operating
systems, and understanding of communication protocols and products.
These technical skills enable firms to effectively manage the technical risks
associated with investing in IT, as discussed previously.
While technical skills are essential in the use and application of IT, they
are usually not sources of sustained competitive advantage. Although these
skills are valuable, they are usually not heterogeneously distributed across
firms. Moreover, even when they are heterogeneously distributed across
firms, they are typically highly mobile. For instance, firms without the
required analysis, design, and programming skills required to make an
IT investment can hire technical consultants and contractors. Specifically,
airlines acquired technical expertise for developing their complex airline
INFORMATION TECHNOLOGY 151

reservation systems by hiring programmers from other airlines and by


making alliances with other carriers and hardware vendors (Copeland and
McKenney 1988).
This mobility of technical IT skills shows that such skills are usually
explicit and codifiable by means of equations, procedures, blueprints, etc.
Since codifiable knowledge ‘can be communicated from its possessor to
another person in symbolic form, the recipient becomes as much “in the
know” as the originator’ (Winter 1987: 171). These codifiable skills are easy
to transmit and receive (Teece 1988). Thus, technical skills can easily diffuse
among a set of competing firms.
If a firm is at a competitive disadvantage because of its inadequate
technical IT skills, it has a variety of obvious solutions. For example, this
firm could train its own employees in the relevant technical skills, hire new
employees that already have the technical skills, ask its employees to take
various classes to learn the relevant technical skills, etc. In all these ways,
a firm at a competitive disadvantage could solve its technical problems
and regain competitive parity in technical IT skills. Consequently, though
there’s no question that technical IT skills are valuable to the firm, they
rarely meet both additional conditions of being heterogeneously distrib-
uted across firms and highly immobile. Without meeting these conditions
from resource-based theory, it is unlikely that technical IT skills can be used
to sustain a competitive advantage.

MANAGERIAL IT SKILLS
Technical skills are not the only skills required to build and use IT applica-
tions. A second broad set of skills are managerial skills (Capon and Glazer
1987). In the case of IT, managerial skills include management’s ability to
conceive of, develop, and exploit IT applications to support and enhance
other business functions. Examples of important IT management skills
include: (a) the ability of IT managers to understand and appreciate the
business needs of other functional managers, suppliers, and customers;
(b) the ability to work with these functional managers, suppliers, and cus-
tomers to develop appropriate IT applications; (c) the ability to coordinate
IT activities in ways that support other functional managers, suppliers,
and customers; and (d) the ability to anticipate the future IT needs of
152 RBT AND ORGANIZATIONAL CAPABILITIES

functional managers, suppliers, and customers. Managerial IT skills enable


firms to manage the market risks associated with investing in IT. Firms can
acquire technical IT skills by hiring programmers and analysts. They then
use their managerial IT skills to help programmers and analysts fit into an
organization’s culture, understand its policies and procedures, and learn to
work with other business functional areas on IT-related projects.
That these managerial skills are valuable is almost self-evident. Without
them, the full potential of IT for a firm will almost certainly not be realized.
How frequently different competing firms will possess similar IT manage-
ment skills is an empirical question. However, it is reasonable to expect that
close working relationships among those in IT and between IT and other
business functions are not all that common, and thus, these relationships
may be heterogeneously distributed across firms.
Unlike technical IT skills, managerial IT skills are often developed over
longer periods through the accumulation of experience by trial-and-error
learning (Katz 1974). Skills developed in this way are called ‘learning-
by-doing’ skills (Williamson 1975). For example, friendship, trust, and
interpersonal communication can take years to develop to the point where
IT managers and managers in other business functions are able to effec-
tively work together to create and exploit novel IT applications. Thus,
history is important for developing these skills. Managerial skills in many
cases are tacit (Castanias and Helfat 1991) and may involve hundreds to
thousands of small decisions that cannot be precisely imitated. As long
as these skills are part of the ‘taken-for-granted’ part of a firm’s skill base,
they may remain causally ambiguous. Finally, the development and use of
many of these managerial skills depend on close interpersonal relation-
ships between IT managers and those working in the IT function, between
IT managers and managers in other business functions, and between IT
managers and customers. Thus, the development of these skills is often a
socially complex process. Therefore, if managerial IT skills are valuable and
heterogeneously distributed across firms, then they usually will be a source
of sustained competitive advantage, since these relationships are developed
over time; and they are socially complex and thus not subject to low-cost
imitation.
Of course, while many managerial IT skills are developed over long
periods and are causally ambiguous and socially complex, not all such
skills have the attributes needed to be sources of sustained competitive
INFORMATION TECHNOLOGY 153

advantage. In general, when managerial IT skills can be written down,


codified, and transferred at low cost and with little loss in richness or
understanding, those skills are not likely to be sources of sustained com-
petitive advantage. On the other hand, when managerial IT skills cannot
be written down, codified, or transferred at low cost or without significant
loss of richness and understanding, those managerial IT skills may be a
source of sustained competitive advantage.
Consider two examples. It has been suggested that management’s under-
standing of the potential for IT to be a source of competitive advantage
was important for American Airline’s ability to develop the SABRE system
(Copeland and McKenney 1988). Moreover, the close relationship between
American Airline’s IT personnel and personnel in other business functions
enabled these groups to work together, to make and learn from mistakes,
and to build on successes in a way that led to the SABRE system. If manage-
ment at American Airline had not been committed to the innovative use of
IT, or if relationships between the IT function and other business functions
had not been cooperative, the SABRE system may never have been devel-
oped or implemented. Imitation of the SABRE system was slowed, while
other airlines developed the IT management skills necessary to develop
these systems.
Wal-Mart’s purchase–inventory–distribution system, which has allowed
a reduction in its cost of sales 2–3 percent below the industry average,
is another example of the importance of managerial IT skills in creating
sustained competitive advantage. A competitively interesting note about
this just-in-time system is that it applies very little proprietary technology
and uses very few inimitable IT technical skills. Instead, IT is used to
support constant and direct communication among Wal-Mart’s stores, dis-
tribution centers, and suppliers. It is this constant communication and the
relationships it builds that has enabled Wal-Mart to retain its competitive
advantage despite the successful efforts of many of Wal-Mart’s competitors
to imitate Wal-Mart’s hardware and software (Stalk, Evans, and Shulman
1992). Put differently, while Wal-Mart’s technical IT skills have been imi-
tated, its IT management skills have been shown to be a source of sustained
competitive advantage.
Part of Wal-Mart’s advantage results from its ability to link its IT func-
tion with its stores, its distribution centers, and even with its suppliers. This
suggests that managerial IT skills are relevant not only in linking different
154 RBT AND ORGANIZATIONAL CAPABILITIES

functions within the same firm, but may also be important in linking dif-
ferent firms in ways that generate IT-based competitive advantages through
strategic alliances. It may also be the case that managerial IT skills can be
used to link a firm with its customers (Jackson 1985). In all these cases, if
the linkages are valuable, if they are possessed by relatively few competing
firms, and if they are socially complex (and thus imperfectly mobile), they
may be sources of sustained competitive advantage.

Empirical examination of resource-based arguments

Recently, some of the empirical implications of these arguments have been


examined (Ray, Barney, and Muhanna 2004; Ray, Muhanna, and Barney
2005). This research focused on the role of IT investments in the customer
service function in North American insurance companies. These studies
examined the impact of the capital required to implement IT, the quality
of a firm’s current IT, the level of a firm’s IT technical skills, and one aspect
of a firm’s IT managerial skills—the quality of the relationship between
IT and customer service managers—on the ability of IT to give a firm a
competitive advantage in the customer service function.
Previous research has shown the value of IT in improving customer ser-
vice in insurance. IT enables customer service workers to gain quick access
to a customer’s policies, evaluate the nature of a customer’s problems, and
help address these problems—either directly or by routing a customer to
the correct person in the organization. Given these implications of IT for
customer service, it is not surprising that insurance companies in North
America have spent billions of dollars on IT over the last several years.
However, as suggested earlier in this chapter, such investments are not
necessarily a source of competitive advantage for a firm in this relatively
mature industry.
Surveys were used to collect information about the IT budget, the quality
of a firm’s current customer service IT, the level of a firm’s technical IT
skills, and the quality of the relationship between IT and customer service
managers within a firm. Several measures of customer service quality were
obtained, both from the survey and from a variety of government sources.
The study hypothesized that the IT budget, the quality of a firm’s current
customer service IT, and the level of a firm’s technical IT skills would all
INFORMATION TECHNOLOGY 155

be unrelated to the relative level of a firm’s customer satisfaction. This


was because, as suggested in this chapter, all these attributes of IT are
tangible and are likely to rapidly diffuse among competitors, especially in
mature industries like the North American insurance industry. It was also
hypothesized that the quality of the relationship between IT and customer
service managers—because it was likely to be socially complex and path-
dependent in nature—was likely to be correlated with the relative level
of a firm’s customer satisfaction. It was also hypothesized that IT budget,
current technology, and IT technical skills would be positively correlated
with relative customer service when the relationship between IT and cus-
tomer service managers was positive. These last hypotheses were tested
using interaction terms in a simple regression.
Results of this analysis were generally consistent with expectations. Cur-
rent technology and technical IT skills were unrelated to relative customer
satisfaction. IT budget was actually negatively correlated—reflecting, per-
haps, the fact that when a firm’s customer satisfaction numbers drop, it
must spend more on IT than its competitors. While not technically con-
sistent with the hypothesized relationship between IT budget and relative
customer satisfaction, this negative relationship is at least consistent with
the notion that spending on IT, per se, is only likely to be a source of
competitive parity.
The quality of the relationship between IT and customer service man-
agers was positively correlated with relative customer satisfaction, as were
the interactions between this variable and current IT and IT technical
skills. That is, not only does the relationship between IT and customer
service managers have a direct positive impact on customer satisfaction—
measured in a variety of ways—but it also makes it possible to leverage a
firm’s current technology and technical IT skills to improve customer sat-
isfaction. All these results are consistent with the resource-based arguments
developed in this chapter.

Conclusions and implications

Of the five attributes of IT studied in this chapter, the resource-based logic


suggests that only IT managerial skills are likely to be a source of sustained
competitive advantage. IT management skills are often heterogeneously
156 RBT AND ORGANIZATIONAL CAPABILITIES

distributed across firms. Moreover, these skills reflect the unique histories
of individual firms, are often part of the taken-for-granted routines in an
organization, and can be based on socially complex relations within the IT
function, between the IT function and other business functions in a firm,
and between the IT function and a firm’s suppliers or customers.
This analysis—and subsequent empirical research—has important
implications for both researchers and managers. For researchers, resource-
based theory suggests that the search for IT-based sources of sustained
competitive advantage must focus less on IT, per se, and more on the
process of organizing and managing IT within a firm. It is the ability of
IT managers to work with each other, with managers in other functional
areas in a firm, and with managers in other firms that is most likely to
separate those firms that are able to gain sustained competitive advantages
from their IT and those that are only able to gain competitive parity from
their IT. These skills, and the relationships upon which they are built, have
been called managerial IT skills in this chapter. Future research will need to
explore, in much more detail, the exact nature of these managerial IT skills,
how they develop and evolve in a firm, and how they can be used to leverage
a firm’s technical IT skills to create sustained competitive advantage.
Also, while the ability of five widely cited potential IT-based sources
of sustained competitive advantage has been examined in this chapter,
there may be other attributes of IT whose competitive implications have
not been fully evaluated. Resource-based theory provides a framework
that can be used to evaluate these competitive implications. Additional
conceptual work will be required to describe these other IT attributes and
their relationship to resource-based theory. Moreover, empirical tests of
the arguments presented here and other resource-based arguments about
IT attributes will also need to be conducted.
This analysis also has important implications for IT managers. First,
simply because IT managerial skills are the only likely source of sustained
competitive advantage discussed in this chapter, it does not follow that
other attributes of IT are competitively unimportant. For example, while
technical IT skills are not likely to be a source of sustained competitive
advantage, they may be a source of temporary competitive advantage. A
firm may be able to get an IT-based head start on its competition based on
these technical skills (i.e. they may be heterogeneously distributed among
competing firms, but not imperfectly mobile). Moreover, even when such
INFORMATION TECHNOLOGY 157

a head start is not possible, it is still essential that a firm be as technically


skilled in its IT as its competitors. After all, managerial IT skills can only
be used to leverage a firm’s technical IT skills if those skills exist in a firm.
Responsible IT managers will constantly compare their technical skills with
their competitors and seek to meet, or exceed, their competition’s level of
technical competence.
Second, this analysis suggests that, in addition to developing and main-
taining a technically competent IT organization, IT managers also should
seek to develop close working relationships with managers in other busi-
ness functions and even with managers in other firms. Clearly, these rela-
tionships are sometimes difficult to build and often difficult to maintain.
However, it is these kinds of relationships that will enable the IT function to
leverage its technical IT skills to address real business problems. Moreover,
to the extent that these kinds of relationships are heterogeneously distrib-
uted across a firm’s competitors, they are likely to be a source of at least a
temporary competitive advantage. Indeed, since these relationships are, by
definition, socially complex, they are also likely to be imperfectly mobile
and thus a source of sustained competitive advantage.
Finally, this analysis suggests that using IT to gain sustained competitive
advantage is not likely to be easy. Indeed, if it was relatively simple for
firms to use IT in this way, then IT would not be imperfectly mobile and
therefore not a source of sustained competitive advantage. The fact that it
is often difficult to develop IT managerial skills, relationships between the
IT function and other business functions are often slow to evolve, and the
technical orientation of many of those in the IT function can clash with
the business orientation of others in a firm is good for those firms who
have been able to develop these IT managerial skills. This implies that other
firms will have a difficult time imitating these skills, and therefore they can
be a source of sustained competitive advantage.

NOTES

1. See Clemons and Weber (1990) for a broader classification of technological risks for
IT projects.
2. Indeed, there is even some evidence that suggests that the cost of imitating another
firm’s proprietary technology is often much less than the cost to the original firm of
developing that technology (Lieberman and Montgomery 1988).
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Part III
RBT and Organizational
Strategies
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8 Resource-based
theory and vertical
integration∗

In a world of corporate refocusing, downsizing, and outsourcing, one


of the most critical strategic decisions that senior managers must make
is determining their firm’s boundary. Questions such as, ‘Which busi-
ness activities should be brought within the boundary of the firm?’ and,
‘Which business activities should be outsourced and managed through
some form of strategic alliance?’ and, ‘Which business activities should
be outsourced and managed through some form of “arm’s-length” market
process?’ are all essential in determining a firm’s boundary. Firms that bring
the wrong business activities within their boundaries risk losing strategic
focus and becoming bloated and bureaucratic. Firms that fail to bring the
right business activities within their boundaries risk losing their compet-
itive advantages and becoming ‘hallow corporations’ (Jones 1986; Postin
1988).
Fortunately, there is a well-developed approach for determining a firm’s
boundary in the field of strategic management and organizational eco-
nomics. Called transactions cost economics, TCE, (Williamson 1975, 1985),
this theory specifies, in some detail, the conditions under which firms will
want to manage a particular economic exchange within their organiza-
tional boundary, the conditions under which firms will want to manage
an exchange through some form of strategic alliance, and the conditions
under which firms will want to manage an exchange through some form of
market contracting.
Moreover, not only is this theory well developed, it is also remarkably
simple. Indeed, in its most popular version, this theory requires managers
to consider only a single characteristic of an economic exchange—the
∗ This chapter draws from Barney (1999).
162 RBT AND ORGANIZATIONAL STRATEGIES

level of transaction-specific investment in an exchange—in order to make


decisions about whether to include that exchange within the boundary of
a firm. Exchanges characterized by low transaction-specific investments
should be managed through arm’s-length market relations; those char-
acterized by moderate levels of transaction-specific investment should be
managed through intermediate strategic alliances; those characterized by
high levels of transaction-specific investment should be brought within the
boundaries of a firm and managed through hierarchical means. This last
type of governance constitutes vertical integration.
Not only is TCE a highly developed and simple theory for determining a
firm’s boundary, it has been subjected to numerous empirical tests. Many
of the empirical tests of this theory have been consistent with its major
predictions (Mahoney 1992; Barney and Hesterly 2006), and thus support
the major boundary-defining prescriptions of TCE. Some of the secondary
predictions of TCE, especially those that deal with the role of uncertainty in
determining a firm’s boundaries, do not receive as consistent support as its
major predictions. Also, many transactions cost predictions do not seem to
hold well in high technology industries (Mahoney 1992). However, despite
these qualifications, to date, the simplest conclusion one can make about
transactions cost economic analyses of firm boundary decisions is that this
form of analysis seems to work.
So, in the face of this well-developed, empirically robust theory, what
if anything does resource-based theory have new to say about vertical
integration and defining a firm’s boundary? The answer is—quite a bit.
As it is currently developed, TCE tends to ignore firm resources and
capabilities in making vertical integration decisions. This theory takes the
productive capability of firms in an exchange as given and only focuses on
how gains from trade in an exchange are to be allocated among those firms.
Resource-based theory explicitly focuses on the productive resources and
capabilities of firms and explores the possibility that the choice of gover-
nance cannot be separated from analyzing how the tangible and intangible
resources controlled by firms in an exchange create value in that exchange.
Managers are often mystified by the small role that resources and capa-
bilities play in transactions cost explanations of vertical integration. ‘After
all’, they argue, ‘isn’t the reason that we make choices about how to govern
our various business activities simply an effort to discover the best way to
gain access to the resources and capabilities we need to be successful? And
VERTICAL INTEGRATION 163

aren’t some firms simply better at doing some things than other firms?
Shouldn’t these capability differences have an impact on my decisions
about which business activities I want to include within my firm’s bound-
aries and which I want to manage through alliances or market processes?
And in making these decisions, wouldn’t common sense suggest that the
resources and capabilities controlled by my firm, and the resources and
capabilities controlled by my potential exchange partners, are important in
deciding our firm’s boundary?’
The purpose of this chapter is to explain the conditions under which a
firm’s decisions about how to manage its different business activities should
be significantly affected by the resources and capabilities it controls and
the resources and capabilities that its potential exchange partners control.
When these conditions hold—conditions that are particularly common in
newly created, rapidly evolving, high technology industries—firms should
make boundary decisions that vary significantly from what would be sug-
gested by traditional transactions cost analyses.

A brief summary of transactions cost economic


analyses of firm boundary decisions

In order to set the groundwork for this discussion, it is helpful to begin


by briefly summarizing transactions cost logic as applied to vertical inte-
gration decisions. Three sets of concepts are important in understanding
TCE as applied to firm boundary decisions: governance, opportunism, and
transaction-specific investment.
In TCE, governance is simply the mechanism through which a firm man-
ages an economic exchange. While there are a wide range of governance
options available to most firms, these different governance mechanisms can
generally be grouped into three broad categories: market governance, inter-
mediate governance, and hierarchical governance. Firms use market gover-
nance to manage an exchange when they interact with other firms across
a nameless and faceless market and rely primarily on market-determined
prices to manage an exchange. Firms use intermediate governance when
they use complex contracts and other forms of strategic alliances, including
joint ventures, to manage an exchange. Finally, firms use hierarchical gover-
nance when they bring an exchange within their boundary. In hierarchical
164 RBT AND ORGANIZATIONAL STRATEGIES

governance, parties to an exchange are no longer independent. Rather,


some third party (‘the boss’) has the right to direct the actions taken and
decisions made by the parties to an exchange.
Transactions cost economics suggests that two issues are important
when deciding which of these governance approaches to use: the cost of a
governance mechanism and the threat of opportunism in an exchange. In
general, the more elaborate the governance, the more costly the governance
(D’Aveni and Ravenscraft 1994). Thus, the cost of using market governance
to manage an exchange is less than the cost of using intermediate gov-
ernance to manage an exchange. In turn, the cost of using intermediate
governance to manage an exchange is less than the cost of using hierarch-
ical governance to manage an exchange. If all managers had to worry about
was minimizing the cost of governance, they would always choose non-
hierarchical forms of governance over hierarchical forms of governance,
and they would always draw the boundaries of their firm very narrowly.
However, managers also must consider the threat of opportunism in an
exchange. Opportunism in an exchange exists when a party to that exchange
takes unfair advantage of other parties to that exchange. The threat of
opportunism in an exchange is a function of the level of transaction-
specific investment in that exchange.1 A transaction-specific investment is
any investment that is significantly more valuable in a particular exchange
than in any alternative exchange. The threat of opportunism exists when
one party to an exchange has made a transaction-specific investment, while
others have not made such an investment. The firms that have not made
these investments can ‘hold up’ firms that have.
According to transactions cost logic, firms can use governance to mit-
igate the threat of opportunism. In general, the more elaborate the gov-
ernance mechanism, the more effective it will be in reducing the threat
of opportunism created by transaction-specific investment. Thus, when
exchanges are characterized by very high levels of transaction-specific
investment, hierarchical governance can be used to reduce the threat of
opportunism. When exchanges are characterized by moderate levels of
transaction-specific investment, intermediate governance can be used to
reduce the threat of opportunism. And when exchanges are characterized
by low levels of transaction-specific investment, opportunism is not really
a threat, and firms should opt for the least costly form of governance
available—market governance.
VERTICAL INTEGRATION 165

Thus, the logic for determining a firm’s boundary—at least according to


TCE—is: when the level of transaction-specific investment in an exchange
is high, the high cost of hierarchical governance is more than offset by the
ability of this form of governance to reduce the threat of opportunism,
and thus hierarchy is preferred over intermediate or market forms of gov-
ernance. When the level of transaction-specific investment is moderate,
intermediate forms of governance are preferred over hierarchical forms
of governance, since the moderate threat of opportunism does not justify
the extra cost of hierarchical governance. Intermediate governance is also
preferred over market governance, in these conditions, because there is
some threat of opportunism that cannot be managed through market
governance. Finally, if the level of transaction-specific investment is low,
then the threat of opportunism is also low, and the least costly form of
governance—market governance—is preferred.
Note that in this entire discussion, never once do questions about the
relative resources and capabilities of a firm and its exchange partners arise.
Firm resources and capabilities simply do not play a significant role in
traditional transactions cost analyses of firm boundaries.

Resource and capability considerations in firm


boundary decisions

Only three apparently minor additions to traditional transactions cost logic


lead to the conclusion that resources and capabilities can be an impor-
tant determinant of a firm’s boundary; and hence its vertical integration
strategy. First, it must sometimes be the case that a firm does not possess
all the resources and capabilities it needs to be competitively successful.
Second, it must be very difficult (i.e. costly) for a firm without a particular
resource or capability that it needs to be successful to create that resource
or capability on its own. Third, it must be very difficult (i.e. costly) for
a firm without a resource or capability that it needs to be successful to
gain access to that resource or capability by acquiring a firm that already
has it. When these three conditions hold, the application of traditional
transactions cost logic will lead managers to make boundary decisions that
put the competitive success of their firm at risk. In these settings, resource-
based theory suggests very different governance choices than transactions
166 RBT AND ORGANIZATIONAL STRATEGIES

cost theory. In particular, in these settings, firms may find it necessary to


adopt nonhierarchical forms of governance to gain access to resources and
capabilities they need to be successful—but resources and capabilities they
cannot create on their own and that they cannot gain access to by acquiring
another firm—even though such forms of governance might subject a firm
to high levels of opportunism.

RESOURCE AND CAPABILITY DIFFERENCES ACROSS FIRMS


It is self-evident that firms can vary in the resources and capabilities they
possess. Over time, firms, even if they are operating in the same industry,
make different choices in strategy, technology, geographic location, and so
forth. These differences in choice can exist for a wide variety of reasons,
including the personal preferences of managers in a firm, uncertainty in
the competitive environment facing firms, the financial constraints a par-
ticular firm faces at a particular time, and so forth. Many of these choices
can create important resource and capability differences across firms—the
condition of resource heterogeneity first discussed in Chapter 3.
Consider, for example, Toyota and GM. Both these firms operate in the
global automobile industry. And yet, even the most casual observer can
document important differences in the resources and capabilities of these
two firms. Toyota has well-documented resources and capabilities in lean
production (Womack, Jones, and Roos 1990). It is, on average, able to
manufacture very high-quality cars at very low cost. Despite years of effort,
most observers agree that GM—at least that part of GM that is not the
Saturn Division or the NUMMI joint venture with Toyota—still has not
fully developed this lean production capability.
This is not to suggest that GM does not possess resources and capa-
bilities, resources and capabilities that even Toyota does not possess. For
example, GM has developed a very extensive distribution system in North
America, a capability that Toyota does not have (but would probably like
to have).
Numerous examples could be cited at this point in the discussion. This
is because it is so common for firms, even firms in the same industry, to
differ significantly in the resources and capabilities they possess. Suffice
it to say that, if anything, important capability differences across firms,
VERTICAL INTEGRATION 167

even firms in the same industry, are the rule, not the exception to the rule.
Indeed, in general, the only time that capability differences across firms
in an industry are not likely to exist is when the structure of an industry
completely determines strategic choices of firms in that industry (Bain
1968). In this setting, surviving firms will all have made the same, or at
least strategically equivalent, choices over time—choices that, in the long
run, should lead these firms to develop the same sets of resources and capa-
bilities. However, research in industrial economics suggests that industry
structure completely determines firm strategy only rarely, and thus firms
in an industry should have identical sets of resources and capabilities only
occasionally (Scherer 1980).
Implicitly, TCE acknowledges that firms may have significant capability
differences. For without significant capability differences, there would be
no potential gains from trade. With no potential gains from trade, it would
not be necessary for firms to engage in exchanges that, in turn, would have
to be governed. Thus, a theory about governance choices made by firms
implicitly assumes that firms must differ in the resources and capabilities
they possess. Thus, technically speaking, observing that firms can vary sig-
nificantly in their resources and capabilities does not change the exchange
conditions traditionally studied by TCE. However, capability differences
are discussed here both as a matter of logical completeness and as a matter
of emphasis. While it is true that capability differences are implicitly part
of any transactions cost analysis, these differences generally do not receive
the attention that they often should.
Moreover, not only can firms differ in their resources and capabilities,
but it can sometimes be the case that, in order for a firm to be competitively
successful, it must have access to resources and capabilities that it does not
currently possess. In this setting, a firm with a capability disadvantage has
three basic choices: it can gain access to these resources and capabilities by
cooperating with firms that already possess them (either through market
or intermediate forms of governance), it can create these resources and
capabilities on its own (a form of hierarchical governance), or it can gain
access to them by acquiring a firm that already possesses them (another
form of hierarchical governance).2 The difficulties that can sometimes
attend the two hierarchical governance solutions to a firm not possessing
all the resources and capabilities it needs to be successful are discussed
below.
168 RBT AND ORGANIZATIONAL STRATEGIES

COSTLY TO CREATE RESOURCES AND CAPABILITIES


Not only can there be significant capability differences across firms, even
if firms are operating in the same industry, but these capability differences
can last for long periods. Capability differences can last for long periods
because it can be very costly for firms without a capability to create that
capability. Indeed, as long as the cost of creating a capability is greater than
any benefit that could be obtained from possessing a capability, a firm will
find it in its rational self-interest to not create that capability. This can be
true even if possessing a capability would be very beneficial, as long as the
cost of creating a capability is very high. This is the assumption of resource
immobility first mentioned in Chapter 3.
There are numerous reasons why it might be very costly for a firm to
create a particular capability on its own (Dierickx and Cool 1989; Barney
1991b). Four of these reasons, originally described in Chapter 3 and par-
ticularly important in the case of vertical integration are: (a) the ability to
create a capability in a cost-effective way may depend on unique historical
conditions that no longer exist, (b) the creation of a capability may be
path-dependent, (c ) a capability may be socially complex and thus costly to
create, and (d) the actions a firm would need to take to create a capability
may not be fully known.

The role of history


Sometimes, the ability of a firm to create resources and capabilities in a
cost-effective way may depend on a firm being in the ‘right place at the
right time’ in history. As history moves on, these opportunities can only
be recreated at very high (perhaps infinitely high) cost. A firm that did not
happen to be in the right place at the right time may find it to be essentially
impossible to create a particular capability in a cost-effective manner. This
was the case for Caterpillar, originally described in Chapter 3.

Path dependence
Sometimes, in order to create a particular capability, a firm must go
through a long and difficult learning process. When there is no way to
‘short circuit’ this learning process, it is said to be path dependent. When
learning processes are path dependent, decisions made early on in the
VERTICAL INTEGRATION 169

creation of a capability can have profound impacts on the capability that is


actually created in a firm. While other firms may want to create this partic-
ular capability for themselves, if they have made decisions that have already
put them on another capability creation path, they will need to undo those
decisions, and change their trajectory to the path that will ultimately lead to
the creation of the capability they wish to possess. However, all these efforts
can take time and can be very costly. Thus, in general, when resources and
capabilities are path dependent, they are likely to be very costly to create.
Consider, for example, the capability that some Japanese firms have to
work cooperatively with their suppliers. Many US manufacturers have
coveted these resources and capabilities, in order to gain access to the
low-cost, high-quality supplies that seem to be available to at least
some Japanese firms (Dyer and Ouchi 1993). However, quick creation of
these resources and capabilities among many US manufacturers has been
elusive. This difficulty is understandable when it is recognized that many
Japanese firms have been working with the same network of suppliers for
over 500 years. The experience that develops over 500 years is costly to
create in a short period.

Social complexity
In addition to the role of history and path dependence, sometimes it will be
very costly for a firm to create a particular capability because that capability
is socially complex in nature. Examples of these socially complex firm
resources and capabilities might include a firm’s culture (see Chapter 4),
its reputation among customers and suppliers (Klein, Crawford, and
Alchian 1978), its trustworthiness (see Chapter 5), and so forth. These
kinds of resources and capabilities can enable a firm to pursue valuable
business and corporate strategies. Firms without these resources and capa-
bilities may find it difficult to conceive of, let alone implement, these same
strategies.
However, even though the value of these socially complex resources and
capabilities in enabling a firm to pursue valuable economic opportuni-
ties may be known, it may still be very difficult for a firm without these
resources and capabilities to create them. Socially complex resources and
capabilities are generally beyond the ability of managers to change in the
short term (Porras and Berg 1978a, 1978b). Rather, these socially complex
170 RBT AND ORGANIZATIONAL STRATEGIES

resources and capabilities evolve and change slowly over time.3 It is difficult
to buy and sell trust, friendship, and teamwork. A firm without these kinds
of socially complex resources and capabilities may find it very difficult to
create them on their own.
Consider, for example, the economic performance of the set of ‘vision-
ary’ firms identified by Collins and Porras (1997) in their book, Built
to Last. These well-known firms—including General Electric, Hewlett-
Packard, Johnson & Johnson, Merck, Sony, Wal-Mart, and Disney—are
all organized around unique visions of their roles in the economy, their
responsibilities to their customers and suppliers, and their commitment
to their employees. These socially complex visions have had a profound
effect on the decisions these firms have made and the strategies they have
pursued. Moreover, over the long run, these firms have provided a much
higher return to shareholders than competing firms that are not organized
around these socially complex sets of values and commitments.4 Despite
the well-documented success of these visionary firms over many decades,
many of their direct competitors have simply been unable to create their
own unique visions and thus have been unable to generate the same level
of economic performance. When resources and capabilities are socially
complex—as the visions of these high performing firms are—it can be very
difficult to create them.

Causal ambiguity
Finally, sometimes it is simply not clear what actions a firm should take to
create a particular capability. When the relationship between actions a firm
takes and the resources and capabilities it creates is causally ambiguous, it
can be very difficult to create a particular set of resources and capabilities.
Causal ambiguity about how to create a particular set of resources and
capabilities exists whenever multiple competing hypotheses about how to
create a particular set of resources and capabilities exist and when these
hypotheses cannot be rigorously tested. These conditions are particularly
likely when the sources of a firm’s resources and capabilities are taken-
for-granted, unspoken, and tacit attributes of a firm (Reed and DeFillippi
1990). Such organizational attributes have been described as ‘invisible
assets’ (Itami 1987), and can include an organization’s culture (Barney
1986b) and its unwritten operational routines (Nelson and Winter 1982).
VERTICAL INTEGRATION 171

Clearly, possessing some kinds of invisible assets may enable a firm


to create certain kinds of resources and capabilities. However, when the
assets needed to create resources and capabilities are invisible, it can be
very difficult for firms seeking to create these resources and capabilities to
know what they should do to create them. As long as there are multiple
competing hypotheses about what a firm needs to do to create a particular
set of resources and capabilities, a condition of causal ambiguity obtains,
and firms cannot be sure about what they must do to create them. Not
knowing what to do to create a set of resources and capabilities clearly
increases the difficulty of creating them.
Thus, in some situations, firms without certain resources and capa-
bilities will find it very difficult and costly to create these resources and
capabilities on their own. Whenever the creation of a capability depends
on history or is path dependent, whenever a capability is socially complex,
or whenever its creation is causally ambiguous, it may be very difficult for
firms without a capability to create it on their own.

COSTLY TO ACQUIRE RESOURCES AND CAPABILITIES


If firms cannot create resources and capabilities on their own, they can
still use hierarchical governance to obtain access to those resources and
capabilities by acquiring other firms that already possess them. However,
when it is very costly to acquire firms that already possess these resources
and capabilities, this approach to gaining access to them can be foreclosed.
Stated more precisely, whenever the cost of acquiring another firm in
order to gain access to important resources and capabilities it possesses
is greater than the benefit that can be gained through this acquisition,
acquiring another firm to solve a firm’s capability disadvantages will not be
chosen.
It is well known that acquiring firms must usually pay a premium in
order to acquire a target firm (Barney 1997). However, paying a premium,
per se, to acquire a firm does not necessarily mean that a firm has imple-
mented a foolish strategy. This is especially true when the acquired firm
possesses resources and capabilities that are essential to an acquiring firm’s
competitive success and cannot be created by the acquiring firm on its own
in a cost-effective way.
172 RBT AND ORGANIZATIONAL STRATEGIES

However, there may be other liabilities associated with using an acqui-


sition to gain access to another firm’s resources and capabilities that may
drive the cost of acquisition up to the point that it is greater than any value
that could have been created by gaining access to resources and capabilities.
These other liabilities raise the effective cost of acquiring a firm, and fall
into several categories: (a) legal constraints on acquisitions, (b) the inter-
ests of a target firm’s owners, (c ) the impact of an acquisition on the value
of a target firm’s resources and capabilities, (d) market uncertainty and the
lack of strategic flexibility associated with an acquisition, (e) how broadly
applicable the acquired capability would be in the acquiring firm, ( f ) the
acquisition of unwanted ‘baggage’ in the target firm, and (g ) the difficulty
of leveraging acquired resources and capabilities throughout an acquiring
firm.

Legal constraints on acquisitions


Most obviously, sometimes one firm may want to acquire another, in order
to gain access to resources and capabilities possessed by this other firm,
only to discover that important legal barriers to that acquisition exist.
These barriers can be of at least two types: antitrust barriers to acquisition
and local ownership barriers to acquisition.
Microsoft, for example, several years ago concluded that it wanted to
purchase Intuit, the firm that had developed and marketed the most suc-
cessful home accounting software on the market—Quicken. There was
little doubt that such an acquisition would have benefitted Microsoft—
assuming a reasonable price for Intuit could have been negotiated. Not only
would Microsoft have gained access to Intuit’s programming capability,
they would also have gained access to its installed base of users and to its
reputation in this home accounting software market. However, this acqui-
sition did not pass antitrust scrutiny, and Microsoft had to find another
approach for entering this software application market.5
Countries, for their own political reasons, can place ownership restric-
tions on domestic firms, thereby making it illegal for a nondomestic firm
to acquire a domestic firm. Obviously, this represents a significant barrier
to completing an acquisition. If a domestic firm possesses resources and
capabilities that a nondomestic firm needs, and if a nondomestic firm is
unable to develop these resources and capabilities on its own, it will have
VERTICAL INTEGRATION 173

to find some alternative to acquisition to gain access to those resources and


capabilities.

Interests of a target firm’s owners


Sometimes, the owners of a firm that possesses valuable resources and
capabilities may not want to sell that firm. This is especially common for
privately held, or closely held, firms. In this setting, firm owners often per-
ceive important nonpecuniary benefits from ownership, including social
status in a geographic region, the maintenance of an important family
tradition, personal loyalty to employees, and so forth. In these settings, a
reluctance to sell will have the effect of driving the price of an acquisition
up, often to the point that it is no longer economically viable. When this
occurs, a firm seeking access to resources and capabilities possessed by
this other firm will have to find an alternative to acquisition to gain this
access.
For example, Publicis SA is one of the largest advertising agencies in
Europe. Founded by Marcel Bleustein-Blanchet in 1926 in Paris, Publicis
has grown from a small French operation to a large integrated network
of agencies providing a broad range of advertising, communications, and
public relations services throughout Europe. In the midst of the consoli-
dation of the global advertising market characterized by numerous merg-
ers and acquisitions, Publicis consistently resisted being acquired. Indeed,
Bleustein-Blanchet once turned down an acquisition offer from Saatchi &
Saatchi by saying, ‘Not even for 100 million francs would I sell Publicis.’
Still independent, Publicis entered into a strategic alliance with the US
advertising firm Foote, Cone & Belding (FCB). However, for FCB to gain
access to Publicis’ resources and capabilities, it had to find an alternative to
acquisition (Kanter 1993). This alternative was a joint venture.

The impact of acquisition on resource value


Sometimes, the acquisition of a firm can reduce the value of the resources
and capabilities an acquiring firm is seeking in the acquired firm. Consider,
once again, Publicis. One of this firm’s greatest assets was its long-term
contracts with several large French companies, many of which were at least
partially owned by the French government. However, these French clients
174 RBT AND ORGANIZATIONAL STRATEGIES

strongly preferred working with a French advertising agency. If Publicis


had been acquired by, say, a US advertising agency, the very thing that the
US agency was trying to purchase—Publicis’ relationship with large French
companies—would have been put in jeopardy. In this context, a firm inter-
ested in gaining access to Publicis’ resources and capabilities would simply
have to find an alternative to acquisition, since the act of acquiring Publicis
would have destroyed the resources and capabilities being sought (Kanter
1993).

Strategic flexibility and uncertainty


Under conditions of high market uncertainty, it may not be possible for
a firm to know, with certainty, what resources and capabilities it will
need to successfully compete in the long run. In this setting, a firm has
a strong incentive to retain its flexibility, to move as quickly as possi-
ble to create the required resources and capabilities when uncertainty is
resolved.
In this highly uncertain environment, acquiring another firm in order
to gain access to its resources and capabilities is a less flexible governance
choice than, say, using intermediate or market governance to gain access
to that capability. If one firm acquires another in order to gain access to a
particular capability, only to discover that this capability turns out to not
be valuable, this firm will have to sell off the firm it originally acquired,
since the capability it purchased when it bought this firm has turned out to
not be valuable. On the other hand, if a firm uses intermediate or market
governance to gain access to a particular capability, only to find that that
capability is not economically valuable, the costs of withdrawing from that
form of governance are generally much lower than the costs of selling a
previously acquired firm.
Indeed, there is strong empirical support that suggests that, under con-
ditions of high market uncertainty, firms prefer gaining access to the
resources and capabilities of other firms through various forms of strate-
gic alliances (as forms of intermediate governance) rather than through
acquisitions (Kogut 1991). Only after the market uncertainty facing a firm
is resolved do firms use acquisitions to gain access to these resources and
capabilities. In the meantime, firms prefer to remain flexible in order to
avoid the costs associated with acquiring firms only to discover that the
VERTICAL INTEGRATION 175

resources and capabilities thus acquired turn out to not be economically


valuable.

How broadly applicable a capability is in the acquiring firm


Another reason why acquiring another firm to gain access to its resources
and capabilities may be very costly is that the capability that is being
acquired, while essential, is only applicable in a narrow range of activities
in the acquiring firm or for a very short period in the acquiring firm. This
could happen, for example, if the required resources and capabilities are
only relevant in a small number of stages of the value chain of the firm
contemplating an acquisition. Once this stage of the value chain is com-
pleted, the resources and capabilities of the firm it acquired may no longer
be needed, and this firm should be sold off—a process we have already seen
can be more costly than withdrawing from a market or intermediate forms
of governance.
Consider, for example, a firm developing a new product. Suppose that
this new product requires the use of some specialized technology resources
and capabilities that are not required in any of this firm’s other products. A
very reasonable way for this firm to gain access to these resources and capa-
bilities would be for it to enter into some form of market or intermediate
governance relationship with a firm that already possessed these specific
technical resources and capabilities. Then, when the development of this
product was complete, the relationship between these two firms could be
severed at low cost.
Acquiring the firm with these specialized technical resources and capa-
bilities is a much more costly solution. Certainly, acquiring this firm might
facilitate the use of these technical resources and capabilities in the devel-
opment of the new product, since using a hierarchical form of governance
should be able to solve any transaction-specific investment problems that
might arise between these two firms if nonhierarchical forms of governance
were used to manage this exchange. However, the cost of dismantling this
hierarchical form of governance would be much higher than the cost of dis-
mantling nonhierarchical forms of governance. And since the firm needing
access to these technical resources and capabilities knows that it only needs
them for the development of a particular product for a relatively short
period, this firm knows that it will almost certainly want to divest itself
176 RBT AND ORGANIZATIONAL STRATEGIES

of this firm once this specific product is developed. To avoid these almost
certain costs, a firm may opt for less hierarchical forms of governance,
even if those forms of governance do not fully protect it from potential
opportunistic actions of its exchange partner.

The acquisition of unwanted baggage and diffused resources


and capabilities
Also, acquiring another firm almost always involves acquiring resources
and capabilities that the acquiring firm does not need or want (Hennart
1988; Kogut 1988). Firms are bundles of resources and capabilities that
are often difficult to disentangle. A particular capability may not be con-
veniently located in a single division, or a single group, in another firm.
Rather, that capability may be spread across multiple individuals, divisions,
and groups around the world in another firm. These kinds of diffused
resources and capabilities cannot be easily separated from the firm where
they are operating. In this setting, a firm seeking to gain access to the
diffused resources and capabilities of another firm may have to acquire the
entire firm to do so.
Whenever an entire firm is acquired, both desirable and undesirable
resources and capabilities are acquired. Moreover, an acquiring firm must
pay for both the resources and capabilities it desires, and the resources
and capabilities it does not desire—because some other firm may desire
precisely the same resources and capabilities that this firm finds undesir-
able. If the desirable resources and capabilities can be separated from the
undesirable resources and capabilities in the acquired firm, the problem of
acquiring unwanted capability baggage in an acquisition can be solved by
simply spinning off those parts of the acquired firm that are not important
to the acquiring firm. While there may be some costs associated with selling
off these unwanted parts of the firm (costs that increase the effective cost
of using acquisitions as a way to gain access to another firm’s resources and
capabilities), at least the firm can gain access to just those parts of another
firm that are strategically most relevant.
However, when a firm’s resources and capabilities are diffused through-
out its organization, it may be impossible to separate the desirable from the
undesirable, the core from the baggage. In this setting, acquiring the bag-
gage in order to gain access to some important resources and capabilities
VERTICAL INTEGRATION 177

significantly increases the cost of acquisition. Indeed, the effective cost of


the acquisition can rise to the point that it is greater than whatever benefit
would have been created by gaining access to an acquired firm’s resources
and capabilities.

Leveraging an acquired firm’s resources and capabilities


Even if none of the other problems with acquiring another firm to gain
access to its resources and capabilities exists, such an acquisition can still
be very costly. This is because it is often difficult to leverage the acquired
resources and capabilities across the relevant parts of the acquiring firm’s
operations.
Research indicates that many acquisitions fail (Porter 1987). By far, the
most important reason for this failure is the inability of acquiring firms
to take full advantage of the resources and capabilities of the firms they
have acquired (Haspeslagh and Jemison 1987). These difficulties in inte-
gration stem from differences in culture, systems, approach, and so forth.
Such differences can significantly raise the effective price of an acquisition
designed to provide a firm the resources and capabilities it needs to be
competitively successful. Thus, even if a firm knows that another firm has
the resources and capabilities needed to be competitively successful, it does
not follow that this firm will always be able to acquire this other firm to gain
access to its resources and capabilities. Even if an acquisition occurs, diffi-
cult leveraging problems can emerge, preventing a firm from gaining the
capability access it needs. Of course, these integration difficulties increase
dramatically if an acquisition is in any sense unfriendly.

Bringing resources and capabilities back into


governance choices

When the three conditions outlined in this chapter exist—when a firm does
not possess all the resources and capabilities it needs to be competitively
successful, when it is very costly for firms without resources and capabilities
to create them on their own, and when acquiring another firm to gain
access to its resources and capabilities is very costly—the major predictions
and prescriptions of TCE with regard to governance choices can change. It
178 RBT AND ORGANIZATIONAL STRATEGIES

is not that problems of opportunism stemming from transaction-specific


investment are unimportant when these three conditions exist. Rather, it
is simply that additional considerations come into play—considerations
that can lead firms to make very different governance choices than would
be expected if transaction-specific investment and opportunism were the
only issues that were being considered.
Imagine a situation where one firm requires the resources and capabili-
ties possessed by a second firm, where the threat of opportunism stemming
from transaction-specific investment in an exchange between these firms is
very high, and the three other conditions mentioned in this chapter exist.
The threat of opportunism due to high transaction-specific investment
suggests that, all things being equal, a firm would prefer to use hierarchical
governance to manage this exchange rather than either intermediate forms
of governance or market forms of governance.
As suggested earlier, there are two ways that a firm could use hierarchical
governance to gain access to these valuable resources and capabilities. First,
it could create these resources and capabilities within its own organiza-
tional boundaries. However, if, for any of the reasons described above, the
cost of creating these resources and capabilities is high, this governance
option may not be available to a firm. Second, it could gain access to these
resources and capabilities by acquiring a firm that already possesses them.
However, if, for any of the reasons described above, the cost of acquiring
this firm is high, this governance option also may not be available to a
firm.
In this setting, a firm may find it too costly to choose hierarchical
forms of governance to gain access to a capability. If the value of gaining
access to this capability is greater than the cost of any opportunism that
might occur by using nonhierarchical forms of governance to manage this
highly transaction-specific investment, this firm will opt for nonhierarchi-
cal forms of governance, and accept any residual opportunism as simply
part of the cost of obtaining access to a very valuable capability.
Put differently, rather than simply being driven by the value of gain-
ing access to a capability and the threat of opportunism stemming from
transaction-specific investments, governance choices in this setting are
driven by: (a) the value of gaining access to a capability, (b) the cost
of opportunism due to transaction-specific investment in an exchange,
(c ) the cost of creating a capability, and (d) the cost of acquiring another
VERTICAL INTEGRATION 179

firm to gain access to a capability. If the cost of creating a capability and


the cost of acquiring another firm to gain access to a capability are greater
than the cost of opportunism due to transaction-specific investment, but
less than the value created by gaining access to a capability, firms will
choose nonhierarchical forms of governance to gain access to this capability
rather than hierarchical forms of governance. This is an example of a firm
engaging in an exchange characterized by high levels of transaction-specific
investment rationally choosing to manage this exchange with nonhierar-
chical forms of governance.
Of course, even when a firm in this situation decides to choose
nonhierarchical forms of governance to manage exchanges with high levels
of transaction-specific investment, it will not abandon efforts to minimize
the threat of opportunism in this exchange. Assuming that both intermedi-
ate and market forms of governance are available to this firm, and assuming
(as does traditional TCE) that intermediate forms of governance are more
effective at controlling the threat of opportunism than market forms of
governance, it seems reasonable to expect that a firm in this situation will
prefer the use of intermediate forms of governance over market forms of
governance.

How common are these exchange conditions?

At this point, a careful reader is probably asking: so what? All this discus-
sion of the value of gaining access to a capability, the cost of creating a
capability, and the cost of acquiring a firm to gain access to a capability
is only relevant if the conditions described above actually exist in some
industries. If these conditions are very rare, then the issues raised here
are managerially irrelevant. However, while ultimately the frequency with
which these conditions exist in different industries is an empirical ques-
tion, we believe that these conditions are not uncommon, at least in some
types of industries. In fact, there is a class of industries where these three
conditions, if anything, are probably quite common. These industries are
newly created, rapidly evolving, high technology industries. Examples of
these industries include biotechnology, microelectronics, certain sectors of
computer software, and so forth. Consider how likely it is for these kinds
of industries to have the three conditions described in this chapter.
180 RBT AND ORGANIZATIONAL STRATEGIES

CAPABILITY DIFFERENCES ACROSS FIRMS


Because these industries are newly created, it is not unusual for different
firms in them to have very different sets of resources and capabilities. The
homogenizing effects of industry structure, mergers and acquisitions, and
consolidation have not yet occurred in these kinds of industries, assur-
ing that important capability differences are likely to exist across firms
that operate in them. Firms in these industries often find that they need
resources and capabilities that they do not possess if they are to be com-
petitively successful. Thus the first of the three conditions described in this
chapter seems likely to exist in these kinds of industries.

COSTLY TO CREATE RESOURCES AND CAPABILITIES


Resources and capabilities in these industries are also often costly to create.
History matters in these industries, and technology trajectories of different
firms are highly path dependent. For example, firms that desire to create
the capability of large scale manufacturing in the biotechnology industry
almost certainly must have first created the capability to successfully man-
ufacture in smaller batches (Pisano 1995). Firms that want to create the
capability of writing complex software must first create the capability to
write software modules within these complex programs, and second, they
must create the capability of continuously integrating these modules to
create their software products (Blackburn, Hoedemaker, and Van Wassen-
hove 1996). There is no known way to short circuit these path-dependent
processes.
Firms in these industries also vary in the extent to which they use socially
complex resources and capabilities pursue strategic objectives. Research in
the pharmaceutical industry, for example, suggests that some firms are very
skilled at integrating product development efforts across multiple scientific
disciplines, while other firms are less skilled in this way (Henderson and
Cockburn 1994). These socially complex differences between firms are
costly to overcome in the short to medium term.
Finally, given the high level of uncertainty in these industries, there can
be a great deal of causal ambiguity about how to develop resources and
capabilities that are critical to success in them. Often, this is due to the
underdeveloped scientific knowledge that underpins these industries. For
VERTICAL INTEGRATION 181

example, in biotechnology manufacturing, even the most capable firms are


often unable to successfully complete all their manufacturing efforts, let
alone able to explain to other firms how to create this capability (Pisano
1995). This lack of scientific knowledge, together with the thousands of
small decisions that make up some of the core processes in these indus-
tries, makes causal ambiguity in these industries very high, and the cost
of creating at least some strategically important resources and capabilities
essentially infinite.
Taken together, these attributes of newly created, rapidly evolving, high
technology industries suggest that it will often be costly for firms to create
at least some competitively important resources and capabilities on their
own, and thus that the second condition described in this chapter may
frequently exist in these industries.

COSTLY TO ACQUIRE RESOURCES AND CAPABILITIES


The cost of acquiring another firm to gain access to its resources and
capabilities can also be very high in these newly created, rapidly evolving,
high technology industries. Over and above any legal, ownership, and asset
value constraints that might exist, high uncertainty about the future puts
a premium on maintaining flexibility in these industries leading firms to
avoid using less flexible acquisitions as a way to gain access to a firm’s
resources and capabilities (Pisano 1995). Given the rapidly changing tech-
nical needs of firms in these kinds of industries, it is not unusual for a
very specific capability to only be required by a firm for a limited range
of activities or for a very short period for highly specialized purposes.
Indeed, research in these industries has shown that the entire time scale of
competition is much shorter than in other kinds of industries (Eisenhardt
and Brown 1998). Temporariness increases the cost of using acquisitions
to gain access to resources and capabilities. It is also not uncommon for
resources and capabilities in firms operating in these kinds of industries
to be highly diffused across the firm—implying that acquiring these firms
may often lead to acquiring bundles of unwanted resources and capabilities
along with those resources and capabilities that are desired through an
acquisition. Finally, differences in culture, differences in procedures, and
other differences among firms in these kinds of industries can make it very
182 RBT AND ORGANIZATIONAL STRATEGIES

difficult to integrate new acquisitions to gain full access to the resources


and capabilities in these firms.
Taken together, these attributes of newly created, rapidly evolving, high
technology industries suggest that it will often be costly to acquire other
firms in order to gain access to their resources and capabilities, and thus
that the third condition described in this chapter may frequently exist in
these industries.
Newly created, rapidly evolving, high technology industries are not
the only industries that have the characteristics described in this chapter.
Further, all exchanges in this type of industry will not necessarily have
all these characteristics. Considerations of transaction-specific investment
and opportunism are not suggested as being irrelevant in this type of
industry. Clearly, whatever form of governance that firms in this type of
industry choose to gain access to a capability, they will attempt to build
in safeguards that have the effect of reducing the threat of opportunism as
much as possible. What has been proposed here, however, is that gaining
access to valuable resources and capabilities in this type of industry may
take issues well beyond transaction-specific investment and opportunism
into consideration. All things being equal, firms in this type of industry
should adopt less hierarchical forms of governance than what would be
predicted by traditional TCE. Moreover, in these types of industries, firm
resources, and capabilities will play a very significant role in determining a
firm’s governance choices.

Discussion

Thus, in the end, managerial concerns about not including their own firm’s
resources and capabilities and the resources and capabilities of potential
exchange partners into consideration when making firm boundary deci-
sions are warranted. Sometimes, it makes sense to cooperate with another
firm through market or intermediate forms of governance just because that
firm possesses certain resources and capabilities that cannot be accessed in
any other cost-effective way. That there may be risks of opportunism asso-
ciated with gaining access to these special resources and capabilities is true.
But the costs associated with opportunism may be less than the benefits
associated with gaining access to these special resources and capabilities.
VERTICAL INTEGRATION 183

Choosing a firm’s boundary, thus, is not just about reducing the threat
of opportunism; it is also about creating economic value by assembling
the right mix of resources and capabilities through a combination of both
hierarchical and nonhierarchical forms of governance.
Recent empirical work supports the conclusion that resource consider-
ations are important for making vertical integration decisions, over and
above transactions cost considerations. For example, an in-depth case
study by Argyres (1996) found that firms will outsource when suppli-
ers possess superior capabilities, except when firms decide to accept the
temporary higher costs associated with developing capabilities in-house.
Argyres also found that firm capabilities mattered most in vertical integra-
tion decisions when there was either very little overlap of the resources
controlled by two firms or when there was substantial overlap in these
resources.
Leiblein and Miller (2003), in an empirical study of semiconductor firms
make or buy decisions, found that firm-level capabilities and strategies
independently and significantly influence firms’ vertical boundary choices.
Firms having greater experience with a particular process technology were
more likely to internalize manufacturing activities than firms lacking such
production experience. Similarly, firms with high levels of sourcing expe-
rience were more likely to outsource their production than firms that did
not have such experience. While empirical research on the role of capa-
bilities in vertical integration decisions is still developing rapidly, there is
some reason to believe that resource considerations play an important, and
sometimes independent role compared to transactions cost considerations.

NOTES

1. At least a moderate level of uncertainty is also required for transaction-specific


investment to be a potential source of opportunism in an exchange. Without some
uncertainty, it would always be possible for firms in an exchange to write a contract
that fully anticipates all possible states of that exchange, and the rights and respon-
sibilities of each exchange partner in those different states. With such a contract,
the threat of opportunism could always be completely eliminated. Unfortunately, as
suggested earlier, research on the impact of uncertainty on firm governance choices
has not received the consistent empirical support that research on the impact of
transaction-specific investment on governance choices has received (see Mahoney
1992; Barney and Hesterly 1996, for reviews of this empirical literature). For this
184 RBT AND ORGANIZATIONAL STRATEGIES

reason, transaction-specific investment as a source of opportunism is highlighted in


this review of transactions cost logic.
2. Intermediate governance can be used to resolve a firm’s lack of capabilities problem
in at least two ways. First, as mentioned in the body of the chapter, intermediate
governance can be used to gain access to another firm’s capabilities, with little or
no effort on the part of a firm without capabilities to create them. Second, a firm
can use intermediate governance to learn how to create the capabilities it does not
possess. However, in order to simplify the discussion, and with no loss of generality,
this second use of intermediate governance will be treated as a special case of using
hierarchical governance to create a capability.
3. This, itself, is yet another example of the importance of path dependence in develop-
ing some capabilities.
4. Collins and Porras (1997) estimate that $1 invested in their sample of 18 ‘visionary
firms’ in 1926 would have been worth $6,536 in 1995, while $1 invested in a matched
sample of firms competing over this same time period in the same industries as the
18 visionary firms would have been worth $415 in 1995.
5. See ‘Will Regulators Get Tougher on M&A’, Mergers and Acquisitions, vol. 31, n 1,
July–August, 1996, pp. 42–51 for a discussion of the specific antitrust issues in the
Intuit Microsoft case.
9 Resource-based
theory and corporate
diversification∗

A firm implements a corporate diversification strategy when it operates


multiple businesses within its boundaries. This strategy is one of the most
studied phenomena in the field of strategic management (Berg 2001). A
wide variety of theoretical tools have been used to understand this phe-
nomenon, everything from agency theory (Jensen and Meckling 1976)
to portfolio theory. Depending on these different theoretical perspectives,
corporate diversification has been characterized as a systematic waste of
shareholder’s money (Lang and Stulz 1994; Berger and Ofek 1995, 1999),
as having no impact on shareholder wealth (Bradley, Desai, and Kim 1988;
Graham, Lemmon, and Walf 2002; Villalonga 2004), and as having a pos-
itive impact on shareholder wealth (Elgers and Clark 1980; Jensen and
Ruback 1983; Schipper and Thompson 1983; Matsusaka 1993; Hubbard
and Palia 1999).
Resource-based theorists, almost from the beginning, have also been
interested in the causes and consequences of corporate diversification
(Wernerfelt 1989; Chatterjee and Wernerfelt 1991). Indeed, one of the
most cited explanations of corporate diversification—that firm’s diversify
to exploit their core competencies (Prahalad and Bettis 1986; Prahalad
and Hamel 1990)—is very consistent with, and an early contributor to,
resource-based theory.
This chapter summarizes this traditional resource-based approach to
understanding corporate diversification. In addition, this chapter proposes
an alternative approach to understanding resource-based theory. Where
the traditional theory combines the assumption that firms may have dif-
ferent resources and capabilities that can create value in multiple business
∗ This chapter draws from Barney (2002) and Wang and Barney (2006).
186 RBT AND ORGANIZATIONAL STRATEGIES

settings and the assumption that the value of these resources sometimes
cannot be realized using market forms of governance to explain the emer-
gence of corporate diversification, the alternative approach focuses on how
firms can use corporate diversification to create one type of resource—
firm-specific human capital investments—in the first place.

Resources, market failures, and


corporate diversification

In their very influential article, Prahalad and Hamel (1990) define a firm’s
core competence as ‘the collective learning in the organization, especially
how to coordinate diverse production skills and integrate multiple streams
of technologies.’ Such core competencies have many of the attributes of
resources and capabilities described in Chapter 3 of this book: They are
likely to be path dependent, causally ambiguous, and socially complex.
However, the existence of core competencies, per se, is a necessary, but
not sufficient explanation of why firms will adopt a corporate diversifi-
cation strategy. Consider the following. Suppose a firm possesses a core
competence, A, that can be applied in its current industry, I, but can also
be valuably applied in a second industry, II. Since this single competence
is valuable in both these industries, these industries are, by definition,
strategically related (Markides and Williamson 1994).
However, what different ways can this firm realize the value of its core
competence, A, across these two industries I and II? One option, of course,
would be for this firm to simply begin operations in industry II and then
make sure that those inside this firm that are in charge of operating the
business inside of industry II exploit competence A in doing so. Alterna-
tively, this firm could acquire a firm that is currently operating in indus-
try II, and by integrating this newly acquired business into its boundary,
take advantage of competence A. Both these approaches to realizing the
potential value of competence A in industry II adopt hierarchical forms of
governance (Williamson 1975). And in both these cases, a firm can be said
to be implementing a strategy of corporate diversification.
However, hierarchy is not the only way this value can be realized. At least
two alternatives present themselves. First, this firm could form an alliance
with a firm currently operating in industry II, and realize the potential
RBT AND CORPORATE DIVERSIFICATION 187

value of competence A this way. Alternatively, this firm could license its
competence A to a firm currently operating in industry II. These inter-
mediate and market forms of governance would enable a firm to realize
the value of its core competence, but would not require a firm to actually
change the mix of businesses it engages in within its own boundaries.
That is, these firms would not necessarily have to implement a corporate
diversification strategy to realize the value of the core competence A.
It was Teece’s original (1982) insight that in order for it to be eco-
nomically efficient for a firm to operate multiple businesses within its
boundary, not only must there be core competencies that can create value
across these multiple businesses (although Teece did not use the term ‘core
competence’—it had not yet been invented), but that the value of these
core competencies could not be realized through intermediate or market
forms of governance. Neither valuable core competencies nor market fail-
ures, by themselves, were sufficient to explain the existence of diversified
firms. However, together, they could explain these types of organizations.
Of course, Teece’s original argument (1982) was developed out of TCE,
with its emphasis on transaction-specific investment and the threat of
opportunism as primary determinants of a firm’s governance choices.
However, in this case, TCE and resource-based theories are clearly comple-
mentary. Transactions cost economics arguments suggest that high levels of
transaction-specific investment lead to hierarchical governance. Resource-
based theories suggest that exploiting core competencies that are path
dependent, causally ambiguous, and socially complex will often require
exchange partners to make high levels of transaction-specific investment.
Thus, by bringing these two theories together, it follows that in order to
exploit their core competencies, firms will often have to bring multiple
businesses within their boundaries, that is, firms will need to implement
corporate diversification strategies.
A vast amount of empirical research has attempted to assess the valid-
ity of these arguments. Currently, there is broad consensus that related
diversification (where a firm exploits a core competence in its diversifica-
tion efforts) creates more economic value than unrelated diversification
(where a firm does not exploit a core competence in its diversification
efforts) (Palich, Cardinal, and Miller 2000). This result is consistent with
the RBT/TCE arguments presented here. After all, if a firm is not exploiting
a core competence in its diversification strategy, then it is not likely that
188 RBT AND ORGANIZATIONAL STRATEGIES

transactions to implement its diversification strategy would be subject to


market failures, and thus, it is not likely that such transactions will need
to be brought within the boundaries of a firm. If such transactions are
brought within the boundaries of a firm, then the inefficiencies created
will lead to low levels of performance. Thus, related diversifiers—where the
exploitation of core competencies is more likely to lead to market failures—
are likely to outperform unrelated diversifiers.
While there is broad consensus that related diversification outper-
forms unrelated diversification, there is less consensus about whether
diversification—of any kind—outperforms no diversification, a so-called
focused or single business strategy. In their very influential papers, Lang
and Stultz (1994) and Comment and Jarrell (1995) showed that diversified
firms traded at a significant discount compared to a portfolio of focused
firms operating in the same industries as a diversified firm. This result sug-
gested that, on average, diversification—including diversification designed
to exploit core competencies—destroyed economic value. One explanation
of this result was that the organizational costs of implementing corporate
diversification—including the cost of inefficient internal capital markets
(Gomes and Livdan 2004)—were simply greater than any value created by
exploiting core competencies across multiple businesses.
A second group of scholars, including Campa and Kedia (2002),
Villalonga (2004a, 2004b), and Miller (2004), showed that, controlling for
a firm’s growth options in its current businesses, that corporate diversi-
fication either did not destroy value or might even create value for its
shareholders. Suppose, for example, a firm was generating significant free
cash flow in a mature or declining business. In such industries, there are
limited growth options and it might make sense for a firm to invest some of
its free cash into business opportunities that have more significant growth
options. This would especially be the case if these growth options exploited
one or more core competencies possessed by a firm (Miller 2004). Using
a two-stage methodology, many of these authors were able to document
either that diversification did not destroy value, or that it, in fact, did create
value for a firm’s shareholders.
However, even more recently, Mackey and Barney (2006) have shown
that this diversification premium literature is incomplete. In particular,
when a firm with limited growth options generates free cash flow, it has two
broad options: First, it can use this cash to invest in new business activities
RBT AND CORPORATE DIVERSIFICATION 189

(i.e. it can engage in related corporate diversification) or, second, it can give
this cash back to its shareholders, either in the form of a dividend or a stock
buyback program. Employing the same two-stage methodology used by
previous scholars, but simultaneously controlling both for the likelihood of
a firm to diversify (because of limited growth options) and the likelihood
of a firm to give cash back to its shareholders (through dividends or stock
buybacks), Mackey and Barney (2006) find that firms that only give cash
back to their shareholders create economic value, firms that give cash back
and diversify do not create or destroy value, and firms that just diversify
destroy value. These results hold even if the level of strategic relatedness
in the diversification strategies used by a firm are controlled for. Once
again, these results are consistent with the observation that the costs of
diversification may be greater than the benefits created by exploiting a
firm’s core competencies.

Diversification and the creation of core competencies

Much of this corporate diversification literature takes the existence of core


competencies as given and asks, ‘What is the most efficient way to exploit
the value of these core competencies?’ Diversification is one of the answers
that is provided to this question.
However, a logically prior question is also possible. That question is:
‘Where do core competencies that might be exploited across multiple
businesses come from in the first place?’ In answering this question, it is
possible to show that over and above any effect that core competencies
might have on diversification, diversification might have an impact on the
development of core competencies.
Indeed, there is a paradox at the heart of current resource-based
theories of superior firm performance. On the one hand, these theo-
ries recognize that employee firm-specific investments are among the
most important sources of economic rents for firms (Barney 1991a).
Employee firm-specific investments—including employee knowledge of
how a firm operates, knowledge about a firm’s key suppliers and customers,
and knowledge about how to work effectively with other employees—
often meet the criteria established in resource-based logic for generating
sustained competitive advantages (Dierickx and Cool 1989; Barney 1991a).
190 RBT AND ORGANIZATIONAL STRATEGIES

The rents generated by these firm-specific investments are often shared


between a firm’s employees and its owners (Becker 1964; Hashimoto 1981;
Rumelt 1987) and thus can be a source of wealth for both the employees
and the owners.1
On the other hand, a great deal of research in organizational economics
suggests that employees who make firm-specific investments risk oppor-
tunistic actions by the firms in which they invest (Williamson 1985). Once
employees make firm-specific investments, firms can systematically extract
wealth from these employees and employees have few ways they can pro-
tect themselves. Indeed, the hazards associated with making firm-specific
investments are so significant that, absent some protection, current the-
ories suggest that employees will avoid making firm-specific investments
altogether (Alchian and Demsetz 1972).
A great deal of research has documented ways that employees can pro-
tect themselves against the threat of opportunistic behaviors if they make
firm-specific investments (Williamson 1975, 1985). Additional work has
identified ways that firms can credibly reassure employees that they will
not behave opportunistically in such settings (Jensen and Meckling 1976;
Grossman and Hart 1986; Castanias and Helfat 1991; Rajan and Zingales
1998). With these protections and reassurances in place, current theory
seems to suggest that employees will be willing to make firm-specific
investments.
However, beyond the threat of opportunism that plagues specific invest-
ments made by employees, there is another risk accepted by employees
making these investments that has received less attention in the literature.2
This is the risk that the value of the underlying assets controlled by a firm—
the assets that an employee makes investments specific to—will fall. If these
assets drop in value, then the value of the investments made by employees
that are specific to these assets will also fall. This will be the case even if
none of the parties in this exchange engage in opportunistic behaviors.
Employees may be very reluctant to make firm-specific investments when
the future value of a firm’s underlying assets is very risky, even if protec-
tions and reassurances are in place that effectively eliminate any threat of
opportunism in this exchange.
Here, the implications for both employees and firms of these risky assets
are examined. For employees, it is shown that risky core firm assets can
RBT AND CORPORATE DIVERSIFICATION 191

reduce employee incentives to make firm-specific investments, even when


there is no threat of opportunism in these exchanges. Some actions firms
can take to address concerns employees might have about making spe-
cific investments in risky firm assets are discussed. These actions include
directly compensating employees for risk bearing and engaging in a par-
ticular type of corporate diversification—resource-based product market
diversification. This latter mechanism is then explored in detail, and the
implications of this analysis for the theory of diversification are then dis-
cussed. We begin by developing a simple model of employee decisions
about whether to invest in firm-specific human capital that depends both
on the threat of opportunism in this exchange and the riskiness of the value
of a firm’s underlying assets.

A MODEL OF EMPLOYEE DECISIONS TO MAKE


FIRM-SPECIFIC INVESTMENTS
Two kinds of resources are important in a model of the employee deci-
sion to make firm-specific investments: (a) the rare and costly to imitate
resources controlled by a firm that an employee is contemplating making
specific investments in, and (b) the resources controlled by an employee
that will be modified if specific investments are made. Here, the first kind
of resource is called a ‘core firm resource’ and the second kind is called a
‘human capital resource’.
Of course, not all the resources controlled by a firm are rare and costly
to imitate—that is, not all the resources controlled by a firm are core firm
resources as defined here. Indeed, many noncore firm resources, that is,
many firm resources that are not rare or costly to imitate, may be necessary
if a firm is to gain competitive advantages and earn economic rents. How-
ever, these common and imitable resources do not separate firms that have
the potential to gain competitive advantages from those that do not have
this potential. These firms are separated by the rare and costly to imitate
resources they do and do not control.
It is also the case that just possessing rare and costly to imitate resources,
by itself, is usually insufficient for a firm to generate economic rents. In
addition, employees need to know how to exploit these resources through
192 RBT AND ORGANIZATIONAL STRATEGIES

the strategies a firm pursues. As Porter (1991: 108) argued, ‘resources are
not valuable in and of themselves, but they are valuable because they allow
firms to perform activities.’
Noncore firm resources are neither rare nor costly to imitate, and
thus can be exploited by nonspecific human capital investments made by
a firm’s employees. However, core firm resources will generally require
highly firm-specific investments in human capital if they are to be exploited
in a firm’s strategies. That is, employees must understand the nature of
these core resources, develop a working knowledge of how they can be
used in conceiving of and implementing strategies, and how they can
be protected and nurtured over time if they are to be fully exploited in
creating competitive advantages and economic rents. These human capital
investments have little value in alternative settings, but can create a great
deal of value in a particular firm.
Now, consider an employee, i , of a firm choosing an optimal level of
human capital investment specific to a firm’s core resource. The amount
(units) of specific investments made by this employee is denoted as xi .
It is further assumed that the payoff that the employee is expected to
appropriate from the total rent generated per unit of his/her specific
investment (in combination of the core resource of the firm) is a fraction,
a(0 < a < 1), of the total expected amount of rent generated per unit of
his/her specific human capital investment, r i . r i is in turn an increasing
function of the value of the firm’s core resource, V . The more valuable the
core resource, the more potential rents can be generated from this core
resource (∂r i /∂ V > 0). Thus, the amount of rents appropriated by the
employee is ar i .
Also, assume that the employee incurs an opportunity cost while making
specific human capital investments. The opportunity cost comes from
the fact that instead of making specific human capital investments, the
employee can alternatively make general human capital investments, for
example, developing skills that improve his/her marketability. Since gen-
eral human capital does not suffer the problem of value loss in case of
transferring across business settings, the payoff from the employee’s per
unit general human capital investment is denoted as w̄i , which is assumed
to be a constant.3
The total units of human capital investments, including both specific
and general, is denoted as n (n can also be thought of as the total hours
RBT AND CORPORATE DIVERSIFICATION 193

the employee devotes to making these investments). Since xi is the total


amount of specific investments, the amount of general investments is then
(n − xi ). Thus, the employee’s total payoff, denoted as wi , includes the
payoffs from both his/her specific human capital investments (xi ar i ) and
his/her general human capital investments [(n − xi )w̄i ]:
wi = axi r i + (n − xi )w̄i . (9.1)
The employee then chooses the optimal amount of firm-specific invest-
ments, xi , that maximizes his/her utility. The employee’s concern over
the risk associated with the payoff from his/her investments can be cap-
tured using a risk-averse utility function. The particular form of standard
mean variance utility function is thus chosen to capture the idea that
employee utilities increase with the expected amount of payoff from his/her
investments, E (wi ), but decrease with the risk associated with this payoff,
var(wi ) (Sargent 1987). It follows that the employee solves the following
utility function, subject to his/her payoff constraint4 :
A
max U = E (wi ) − var(wi )
xi 2
where wi = axi r i + (n − xi )w̄i . (9.2)
A is the absolute risk-averse parameter that captures the employee’s degree
of risk aversion. Without loss of generality, the parameter, A, is normal-
ized to 1 (A ≡ 1). The wealth constraint shows that when the employee
increases his/her level of specific human capital investment (higher xi ),
his/her total wealth will covary more with the expected rents generated per
unit of specific human capital investment.
From the first-order condition with the normalized risk-aversion para-
meter (A ≡ 1), the optimal amount of specific human capital investment
chosen by the employee can be obtained as follows (please see appendix of
this chapter for a more detailed derivation):
a E (r i ) − w̄i
xi∗ = . (9.3)
var(ar i )
This equation has several important implications. First, the numerator of
this equation suggests that the optimal amount of specific human capital
investments an employee chooses to make (or, an employee’s incentive to
specialize), xi∗ , depends on the amount of rents the employee is expected
194 RBT AND ORGANIZATIONAL STRATEGIES

to appropriate, aE(r i ), relative to the rents from risk-free general human


capital investments. This is perfectly consistent with previous research in
organizational economics which suggests that employee investments in
firm-specific human capital can generate economic rents, but the will-
ingness of employees to make these investments depends on how much
of the rent they expect to be able to appropriate (Grossman and Hart
1986; Hart and Moore 1990; Castanias and Helfat 1991, 2001; Rajan and
Zingales 1998, 2001). Moreover, a small amount of rent appropriation
suggests that an employee expects significant opportunistic actions on the
part of a firm, while a large amount suggests that an employee does not
expect such actions. Efforts by employees to contractually protect them-
selves from opportunism, and efforts by firms to reassure employees that
they will not behave opportunistically, can both be interpreted as efforts
to guarantee that the employees will realize their expected amount of
rent appropriation and thereby increase the likelihood that these employ-
ees will make specific human capital investments that generate economic
rents.
Second, xi∗ is inversely related to var(ar i ), the risk associated with the
amount of rent that the employee expects to appropriate per unit of his/her
specific human capital investment. This establishes a basis for the analysis
in this chapter: the incentives for an employee to make specific human
capital investment are negatively affected by the risk to the per unit payoff
from his/her specific human capital investment. As r i , the rents generated
from an employee’s specific human capital investment, increases with V ,
the value of the core resource owned by the firm, so does the payoff to the
employee from his/her per unit specific investment, ar i . It then follows
that the riskiness of this payoff, var(ar i ), should also increase with the
riskiness of the value of a firm’s core resources. That is, when the value
of a firm’s core resource falls, so does the value of employee firm-specific
investments and the potential payoff the employee obtains from these
investments. Therefore, the riskier is the value of a firm’s core resources,
the lower the employee’s incentives to make specific human capital
investments.
A lower level of firm-specific human capital investments, in turn,
reduces the total amount of rents that can be generated from the underly-
ing core resources and the amount of rents that is eventually appropriated
by the firm. In this setting, the firm has a motive to adopt mechanisms to
RBT AND CORPORATE DIVERSIFICATION 195

mitigate employee concerns over the risk to the value of the core resource
to induce employees to make these rent generating investments.

MANAGING THE RISK OF FIRM CORE RESOURCES AND EMPLOYEE


INCENTIVES TO MAKE FIRM-SPECIFIC INVESTMENTS
Thus, in order for a firm to induce its employees to make firm-specific
investments, not only must potential opportunism problems in this
exchange be managed, but firms must also discover ways of managing the
risks associated with making human capital investments that are specific
to a firm’s risky core resources. Two possible solutions to this problem are
considered here: (a) compensating employees directly for accepting these
risks, and (b) using resource-based related diversification to mitigate these
risks.

Compensating employees for risk bearing


The most straightforward solution to the employee incentive problem
stemming from the riskiness of a firm’s core resources seems to be for
the firm to directly compensate employees it needs to make firm-specific
investments for bearing this risk. That is, to get these ‘key employees’ to
make firm-specific investments, pay them to do so. Theories and empirical
findings in the strategic management literature indeed suggest that diverse
stakeholders, including a firm’s employees, suppliers, and customers, often
demand compensation for risk bearing (Aaker and Jacobson 1990; Amit
and Wernerfelt 1990; Miller 1998; Deephouse and Wiseman 2000; Miller
and Chen 2003). The expected amount of payment to the employees
should be based on an estimation of the risk to the value of firm core
resources to which these employees are making specific human capital
investments.
These observations lead to the following proposition:
Proposition 1: The higher is the risk associated with a firm’s core resources,
the more likely that the firm’s key employees will have a larger amount of total
expected compensation.

On the other hand, compensating employees for risk bearing has some
limitations in functioning as an effective employee incentive mechanism.
196 RBT AND ORGANIZATIONAL STRATEGIES

First, it can be very difficult to write and enforce a compensation contract


described above (Titman 1984; Hart 1995). Bounded rationality linked
with environmental uncertainty make it difficult, if not impossible, to
identify all the future states of nature that would affect the value of a firm’s
core resources. Even if these states could be anticipated, their specific effects
on the value of core resources and employee specific investments remain
challenging to quantify. Because firm core resources are rare, nontradable
and employee specific human capital investments are nontangible, both are
difficult to value.
Moreover, the firm may default on the terms of compensation contract
in the case of severe negative economic outcome. For example, a firm may
approach bankruptcy when it no longer has valuable assets that allow it to
continue to operate. In such case, terms of contract cannot be effectively
enforced.
Second, although compensating employees for risk bearing can to some
extent create incentives for them to make firm-specific human capital
investments, it directly increases firm expenditures and thus imposes costs
on the firm (Miller and Chen 2003). When the risk associated with firm
core resources is very high, it becomes increasingly expensive for the firm
to compensate employees for risk bearing despite the motivational benefits
of such compensation. As the risk associated with a firm’s core resource
increases, for a given amount effort to make firm-specific investments, the
employee will demand higher compensation resulting in higher marginal
cost per unit effort and no corresponding increase in the expected revenue
for the firm. Therefore, it may not pay for the firm to motivate the employ-
ees beyond a certain point through compensation, because the utility of an
additional unit of effort to make firm-specific investment is worth less to
the firm than the cost of motivating the employees for an incremental unit
of effort. Thus, the optimal compensation schedule often does not fully
compensate the employees for risk bearing (Shavell 1979). This of course
will leave the employees to reduce efforts and underinvest in firm-specific
human capital.
Due to the limitations associated with compensating employees for
risk bearing and the costs of such compensation imposed on the firm,
sometimes the firm may be better off finding additional ways to reduce
the risk associated with core resources. Resource-based product market
diversification is one such alternative.5
RBT AND CORPORATE DIVERSIFICATION 197

Resource-based corporate diversification


Generally, the value of a firm’s core resource is determined in the prod-
uct markets where that resource is deployed (Barney 1991a; Peteraf 1993;
Bowman and Amrosini 2000). This implies that if the firm’s core resources
can be deployed in multiple product markets, the value of the resource in
one product market is likely to be different from that in the other product
markets. Moreover, a change in the value of a core resource in one product
market may not necessarily affect its value in a different product market.
This suggests that the risk associated with core resources can be reduced by
exploring the applicability of these core resources in other product markets
and to diversify accordingly.
Note that diversifying into multiple product markets through deploying
a firm’s core resource does not directly reduce the risk to the resource value
in each individual product market. However, as long as the factors that lead
to changes in one product market are not perfectly correlated with those
in another product market, uncertainty in one product market that has a
significant effect on the value of the core resource in that particular market
is not likely to have a similar effect on that in another market. Therefore,
through diversifying into product markets with less than perfectly corre-
lated environmental factors, the overall risk associated with the value of the
core resource can be reduced. This risk reduction, in turn, can potentially
increase the employees’ incentives to make human capital investments that
are specific to a firm’s core resources.6 Generally speaking, the positive
effect of resource-based product market diversification on employee incen-
tives is expected to increase with the level of the risk associated with the
firm’s core resources in the firm’s original market(s).
These observations lead to:

Proposition 2: The higher is the risk associated with a firm’s core resources, the
more likely that the firm will diversify into other product markets based on
these core resources.

To the extent that resource-based product market diversification can sub-


stitute for compensating employees for risk bearing as the means of
facilitating employee to make firm-specific human capital investments, the
ability for a firm to engage in resource-based diversification can reduce the
need for the firm to pay employees for risk bearing. Therefore,
198 RBT AND ORGANIZATIONAL STRATEGIES

Proposition 3: Ceteris paribus, firms that have diversified based on their core
resources will subsequently compensate their key employees at a lower level
than if they have not diversified in this way.

Note that the arguments above are built on the implicit assumption that
management is able to implement a resource-based diversification strategy
in such a way that the risks of existing businesses of the firm are not
altered. However, to the extent that the existing businesses are disturbed,
the effect of resource-based diversification on risk reduction and therefore
on employee incentives should be discounted accordingly.

IMPLICATIONS FOR THEORIES OF DIVERSIFICATION


Note that the pattern of diversification and the definition of resource relat-
edness discussed above are in spirit very close to those based on the concept
of the ‘strategic asset’ in the resource-based theory of diversification (e.g.
Teece 1982; Markides and Williamson 1994, 1996). To the extent that a
core firm resource is rare and costly to trade, the diversification pattern
predicted here, that is, diversification by deploying core firm resources,
resembles the resource-based theory of corporate diversification, which
argues that multibusiness organizations exist to exploit core competencies
(Teece 1982; Mahoney and Pandian 1992; Peteraf 1993).7 However, there
are some important differences in the pattern of corporate diversification
derived from this theory of diversification and traditional resource-based
theories of diversification. These differences are manifest in the path and
the scope of diversification.

Diversification path
Traditional resource-based logic suggests that diversification is appropriate
when a firm’s resources are applicable across the multiple businesses a firm
engages in (Montgomery and Wernerfelt 1988; Markides and Williamson
1994; Silverman 1999). The logic developed here suggests that risk
reduction, in addition to the ability to apply firm resources across multiple
businesses, may motivate diversification. This suggests that a diversifying
firm will look to exploit its current resources and capabilities in its diversi-
fication moves, but that it will also look for businesses where it can apply
RBT AND CORPORATE DIVERSIFICATION 199

those resources that have cash flows that are uncorrelated with its current
business activities. This suggests the following:
Proposition 4: Firms that diversify into businesses that exploit their current
core resources and that have a pattern of cash flow that is not highly correlated
with their current businesses will generate higher levels of employee firm-
specific investment than firms that diversify into businesses that only exploit
their current core resources but have a pattern of cash flow that is highly
correlated with their current businesses.

Diversification scope
Traditional resource-based logic suggests that there are often decreasing
returns associated with diversification. This is because, generally, firms will
diversify into the highest return related business first, the second highest
return related business second, and so forth. Barring an exogenous shock
that changes the value of a firm’s core assets, the last diversification moves
made by a firm that exploit a particular core resource are likely to be
less valuable than the first few diversification moves made by a firm that
exploited the resource.
The theory of diversification developed here also suggests that returns
from risk reduction (i.e. the willingness of employees to make firm-specific
investments that have rent-generating potential) will also have decreasing
returns. This is because portfolio risk is generally a concave function of the
number of assets in the portfolio (Elton and Gruber 1995), which implies
that with the increase in the number of businesses a firm diversifies into,
the overall risk to the value of the core resources falls but at a decreasing
rate. A decreasing incremental amount of risk reduction is then likely to
lead to decreasing returns for the firm.
However, while both core competence-exploitation and risk reduction
may be characterized by decreasing returns, these two benefits of diver-
sification may not move together over time. Figure 9.1 shows that as a
firm diversifies further away from its original businesses, both the marginal
advantage obtained from exploiting core competencies and that obtained
from providing incentives for employees to specialize are expected to
decrease; and the marginal cost of diversification is expected to increase.
When considering each effect separately, the optimal scope of the firm
is determined by the point where the marginal revenue of diversification
200 RBT AND ORGANIZATIONAL STRATEGIES

a. Costs of diversification
b. Benefits of diversification due to
Marginal increased employee incentives
benefits and
c. Benefits of diversification due to
costs of
economy of scope (Montgomery and
diversification
Wernerfelt 1988)
d. Combined benefits (b and c)

cb d
a

0 OS1* OS2* OS3* Diversification


Distance

Figure 9.1. The determinants of the optimal scope of a firm


Notes: OS1 ∗ is the optimal scope when only the benefit from employees’ increased investment
incentives is considered; OS2 ∗ is the optimal scope when only the benefit from economies of
scope is considered; OS3 ∗ is the optimal scope when both the benefits of economies of scope
and employee incentives are considered

equals marginal cost (OS1 ∗ and OS2 ∗ in Figure 9.1). However, when both
effects are considered, the optimal diversification distance is at OS3 ∗ , where
the marginal revenue of diversification from the combined effects equals to
the marginal cost of diversification.
Of course, the analysis in Figure 9.1 assumes that the benefit from
exploiting core competencies, which is determined by the applicability of
core firm resource (or strategic asset) in other product markets, and that
from providing employee investment incentives, which is determined by
the degree of reduction in risk to the core resource value, are not correlated.
To the extent these benefits are correlated, the optimal diversification scope
would be less than OS∗3 (Figure 9.1). Some strategy scholars have suggested
that businesses that exploit the same underlying core resources can nev-
ertheless have very different patterns of cash flow over time (e.g. Prahalad
and Hamel 1990; Markides and Williamson 1994, 1996), implying a low
correlation between these two benefits from diversification. However, the
extent to which these benefits are correlated is ultimately an empirical
question. All this suggests the following:
RBT AND CORPORATE DIVERSIFICATION 201

Proposition 5: When the benefits of realizing economies of scope and increased


employee incentives to specialize are not perfectly correlated, a firm will diver-
sify more widely than when only one of the benefits is considered. And the opti-
mal diversification scope increases with a decrease in the correlation between
the two benefits.
Finally, it is worth noting that this emphasis on risk reduction from diver-
sification is also related to the argument of agency theory, in which
diversification is used to reduce overall firm risk exposure. The agency
argument, however, considers diversification as an outcome of conflicts
between shareholder and managers since it reduces managers’ employment
risk, but at the expense of the shareholders of the firm (Amihud and Lev
1981). In contrast, this part of this chapter argues that shareholders as
well as employees (including managers) potentially gain from the firm’s
diversification, because diversification encourages employees to join the
firm and to invest in firm-specific knowledge and skills. Another notable
difference between these two perspectives is that central to our argument
is ‘resource-based’ diversification (related), which reduces risks associated
with the core resources. In contrast, agency theory emphasizes conglom-
erate diversification (unrelated), which leads to financial risk reduction,
that is, it smoothes cash flow at the corporate level, but does not effectively
reduce the risk of the underlying core resources.

Conclusion

This chapter shows that resource-based logic can be used to explain how
firms leverage core competencies to operate in multiple businesses simul-
taneously, and to explain how corporate diversification can be used to
help develop one very important type of core competency—firm-specific
human capital investments. In this sense, corporate diversification is both
the effect of core competencies and the cause of core competencies.
Obviously, of these two arguments, the former has received much more
attention than the latter. However, the second argument has some poten-
tially interesting implications for the study of diversification, generally, and
for resource-based theory, in particular.
With regard to the study of diversification, the model developed here
uses a simple linear rent sharing scheme between the employee and firm.
202 RBT AND ORGANIZATIONAL STRATEGIES

Since firm rents are assumed to be normally distributed, so is the amount


of payoff to the employee’s specific investments, suggesting a symmetric
upside and downside risk associated with the employee’s payoff. However,
sometimes a nonlinear payoff function, such as an option-like function
with a component of payment that is fixed, seems to be a more plausible
assumption. These issues concerning the interaction between the payment
and rent sharing function and the shape of the distribution of uncertain
outcomes may be an interesting research direction to be explored in the
future.
Second, we have focused attention on the discussion of the role of core
resources and resource-based diversification as an important mechanism
for reducing the risks associated with these core resources. Nevertheless, it
omits some other relevant strategic questions that deserve future research
attention. For example, when implementing a resource-based diversifica-
tion strategy, what noncore resources should be internalized with the core
resources? How should firm strategies be different in utilizing these differ-
ent types of resources? How do complementary noncore resources affect
the risk associated with core resources? While it is beyond the scope of this
chapter to include the discussion of these issues, future research along this
path will help complete a theory of core resources and employee incentives.
A third area that requires further research efforts is related to the limita-
tion of the applicability of the current framework. The ideas here are most
applicable to firms that face moderate levels of uncertainty, but not to those
that operate in either very stable or extremely volatile environments. In a
stable environment, the value of a firm’s core resource is also likely to be
stable and rents generated from the resource and employee specific human
capital can be sustained over a long period. In this setting, employees have
stronger incentives to specialize and appropriate their share of the rents. On
the other hand, in an extremely volatile environment, rents may become
so short-lived that inducing employees to make specific investments can
be too costly. Furthermore, when changes in environmental factors ren-
der the core firm resource itself obsolete, diversification by deploying the
core resource would no longer be effective in preserving the value of the
resource. In this case, a better strategy for the firm is to develop capabilities
that enable the firm to efficiently adapt to constantly changing and fast-
evolving environments. Although the recent dynamic capabilities literature
(Teece, Pisano, and Shuen 1997) helps address this issue, it is clearly an area
that deserves further research attention.
RBT AND CORPORATE DIVERSIFICATION 203

More broadly, this second line of inquiry raises a fundamental question


that is largely unanswered in resource-based theory: Where do valuable,
rare, and costly to imitate resources come from? This analysis suggests that
a firm’s equityholders have an interest in a firm pursuing a diversification
strategy in order to induce employees to make firm-specific investments,
thus suggesting that valuable, rare, and costly to imitate resources may
reflect strategic choices made by firms. However, this is only one way
these kinds of resources might emerge for a firm and additional work is
required to understand the exact processes by which these resources are
created.

NOTES

1. How much of the rents will be appropriated by the employees, and how much will be
appropriated by the firm’s owners depends on the relative bargaining power of each
party (Coff 1999).
2. Agency theory (e.g. Jensen and Meckling 1976; Shavell 1979; Holmstrom and Mil-
grom 1987; Eisenhardt 1989a) also stresses the existence of a trade-off between risk
and incentives, but with a specific interest in optimal contract design and appropri-
ate corporate governance mechanisms under varying levels of outcome uncertainty,
risk aversion, and information. This argument differs in at least two aspects. First,
although the agency literature also concerns itself to the effect of risk considerations
on agent incentives, it does not directly address the specific incentive problems asso-
ciated with employees making specific human capital investments. Second, due to
contract incompleteness, the optimal contract design emphasized in the agency liter-
ature is rarely the first-best solution (e.g. Shavell 1979). Thus, it almost always leaves
room for firms to adopt strategic risk management mechanisms such as resource-
based diversification strategies.
3. In order to focus our attention on the pure effect of resource risk on employee
incentives to make specific human capital investments, we implicitly assume that
general human capital investments are risk free. But in reality general human capital
investments may not be completely riskless. Incorporating the riskiness of general
human capital would make investment in firm-specific human capital even more
attractive relative to general human capital.
4. The mean variance risk-averse utility function is originally derived from exponential
utility function, which has the form U (C ) = −e−AC , where A is called the Arrow-
Pratt index of absolute risk aversion, given by A = −U  (C )/U  (C ). C is the income
(payoff) distributed normally with mean, Ï, and standard deviation, Û2 . It can then
2
be derived that the agent’s expected utility is E U (C ) = −e−A(Ï−(A/2)Û ) . Hence, the
objective of the employee is to maximize U = Ï − (A/2)Û , which is the same utility
2

function used in the article.


204 RBT AND ORGANIZATIONAL STRATEGIES

5. A strategy of resource-based related diversification directly deals with the risk to


core resource value. This makes such a risk reduction mechanism more appealing in
the context of this argument than some other potential firm-level risk management
mechanisms such as financial hedging and unrelated diversification. However, these
alternative mechanisms may be effective in reducing overall firm-level risk exposure,
but the risk to the value of the fundamental core resources is not likely to be signif-
icantly affected. See Miller (1992, 1998) for a detailed discussion of these alternative
firm-level risk management tools.
6. Note that in addition to the need for employees to make human capital investments
that are specific to a firm’s core resource, a diversified firm may also need to induce
its employees to make investments that are specific to a specific product market that
the firm operates in. This usually requires different firm policies such as appropriate
compensation mechanisms not specifically addressed here. However, this considera-
tion should not directly affect the arguments made here as long as the firm requires
employees to make substantial specific investments at the core resource level.
7. Note that a ‘core resource’ as defined here is not exactly the same as a ‘strategic
asset’. While a strategic asset can be a source of firm rents, a core resource itself does
not generate rents. It can only be source of rents when it is combined with specific
human capital investments by employees. Moreover, Markides and Williamson (1994,
1996) argue that in addition to realizing economies of scope, diversification may help
improve a firm’s current strategic assets and build new ones.

Appendix: Derivation of Equation (9.3)


Plugging the employee payoff constraint wi = axi r i (V ) + (n − xi )w̄i into the util-
ity function, U = E (wi ) − A2 var(wi ), we then have

A A
U = E (wi ) − var(wi ) = axi E (r i ) + (n − xi )w̄i − [xi2 var(ar i )],
2 2
which is to be maximized with respect to xi . With normalized risk-
aversion parameter (A ≡ 1), the first-order condition (with normalized A) for
xi is:

Ux i = a E (r i ) − w̄i − xi var(ar i ) = 0

The xi∗ , the amount of specific human capital investments that maximize the
employee’s utility, can be obtained by solving the above equation for xi .

a E (r i ) − w̄i
xi ∗ = .
var(ar i )
10 Resource-based
theory and mergers
and acquisitions∗

A senior manager at a major US corporation was recently overheard


describing how her firm had successfully ‘snatched’ a strategically impor-
tant acquisition from a bevy of competing firms. Her enthusiasm for this
acquisition was contagious. Not only did this acquisition add economic
value to her firm in the short term, she argued, it also created important
long-term strategic advantages.
This manager’s enthusiasm reflects the widespread belief, among man-
agers and academics alike, that merging with or acquiring strategically
related firms can increase the economic value of successful bidding firms
(Salter and Weinhold 1979). A great deal of effort has gone into describing
the sources of strategic relatedness that exist between a bidding and target
firm (Lubatkin 1987; Singh and Montgomery 1987), and how this relat-
edness is translated into economic profits for the shareholders of bidding
firms once an acquisition is completed (Haspeslagh and Jemison 1987).
This ‘relatedness hypothesis’ in mergers and acquisitions has not gone
untested. Unfortunately, results are not consistent with these managerial
or academic expectations. Lubatkin (1987), for example, found no signif-
icant difference in returns to bidding firm shareholders for strategically
related and unrelated acquisitions. Also, Singh and Montgomery (1987),
despite controlling for the type and degree of strategic relatedness between
bidding and target firms, found that these acquisitions did not generate
superior returns for shareholders of bidding firms. Singh and Montgomery
(1987) did find that the shareholders of related target firms obtain higher
profits than the shareholders of unrelated target firms. Indeed, the results
of numerous studies, reviewed in Porter (1987) and Jensen and Ruback
∗ This chapter draws from Barney (1988).
206 RBT AND ORGANIZATIONAL STRATEGIES

(1983) support this same conclusion: In mergers and acquisitions, the


shareholders of target firms benefit, and the shareholders of bidding firms
do not lose.
These results may at least partially reflect difficult sampling, measure-
ment, and other methodological problems associated with the event study
methods used in this research (Lubatkin 1987; Singh and Montgomery
1987). However, the view developed in this chapter is that the theory of
mergers and acquisitions that underlies this empirical work is also incom-
plete. While acquiring a strategically related firm may create economic
value, in many circumstances this increased value is distributed in the form
of high returns to the shareholders of acquired target firms rather than to
the shareholders of successful bidding firms. Thus, strategic relatedness is
not a sufficient condition for the shareholders of bidding firms to earn
superior returns: in order for relatedness to generate such returns, a variety
of specific conditions must be met.
The purpose of this chapter is to specify the conditions under which
relatedness in mergers and acquisitions can be a source of superior returns
for shareholders of bidding firms. Not surprisingly, these conditions turn
on the attributes of the resources and capabilities that bidding firms are
attempting to leverage through their acquisition strategies. The chapter
begins by providing a financial definition of relatedness, and then describ-
ing the conditions under which acquiring a strategically related target
will not generate superior returns for the shareholders of bidding firms.
Next, conditions where relatedness will generate superior returns for share-
holders of bidding firms, including the existence of private and unique
synergistic cash flows, inimitable and unique synergistic cash flows, and
unexpected synergistic cash flows, are discussed. The chapter concludes by
discussing the implications of these arguments for research and practice.

A financial definition of relatedness

From a financial point of view, two firms are related when the net present
value (NPV) of the cash flow of the combination of these firms is greater
than the sum of the NPVs of the cash flows of these firms acting indepen-
dently (Copeland and Weston 1983):
NPV (A + B) > NPV (A) + NPV (B) (10.1)
MERGERS AND ACQUISITIONS 207

where NPV (X) is the discounted NPV of the cash flows generated by firm
X (Copeland and Weston 1983). When the inequality in equation (10.1)
holds, a synergistic cash flow is created if firm A acquires firm B.
A variety of possible sources of relatedness and synergy in mergers and
acquisitions have been cited in the literature (Williamson 1975; Benston
1980; Eckbo 1983; Jensen and Ruback 1983; Stillman 1983; Harrison
et al. 1991; Goold and Campbell 1998; Hitt, Harrison, and Ireland 2001)
Salter and Weinhold (1979), for example, argued that key business skills
and product market positions are two potentially important sources of
relatedness. From a broader perspective, Lubatkin (1983) classified nine
types of relatedness between bidding and target firms into three categories:
technical economies (e.g. marketing and production economies), pecu-
niary economies (e.g. market power), and portfolio economies (e.g. risk
reduction). Jensen and Ruback (1983) identified eleven potential sources
of strategic relatedness between bidding and target firms. In this chapter,
relatedness between two firms can reflect any one, or any combination, of
these sources, as long as equation (10.1) is satisfied.
Mergers or acquisitions between related firms will have no impact on
the wealth of shareholders of bidding firms when the price paid for a target
firm is exactly equal to the difference between the NPV of the cash flow of
the target and bidder firms combined, and the NPV of the cash flow of the
bidding firms alone. This price, P , is simply the value added to the bidding
firm by acquiring a target:1
P = NPV (A + B) − NPV (A) (10.2)
Note that P does not depend on the value of the target firm acting as an
independent business, but rather on the value that the target firm creates
when it is combined with the bidding firm. If a bidding firm pays P + k
for a target, then that firm has acquired a firm that adds P dollars in
additional value (i.e. NPV (A + B) − PV (A)) for the price P + k. If k = 0,
then a bidding firm has paid the price P for an addition to its cash flow
worth exactly P, and thus the wealth of bidding firm’s shareholders is
unaffected. If k > 0, then this acquisition represents a real economic loss to
the shareholders of the bidding firm. If k < 0, then the shareholders of the
bidding firm will obtain a positive economic return. Thus, specifying the
conditions under which a bidding firm’s shareholders will obtain superior
returns from mergers and acquisitions reduces to specifying the conditions
208 RBT AND ORGANIZATIONAL STRATEGIES

under which the price of an acquisition or merger will be less than P , that
is, specifying the conditions under which k < 0.

Competitive parity for bidding firms from acquiring


related targets

Strategic relatedness between bidding and target firms, as defined in equa-


tion (10.1), is not a sufficient condition for the shareholders of bidding
firms to earn competitive advantages from mergers or acquisitions (Jensen
and Ruback 1983; Lubatkin 1983). If the value of the combined cash
flow of target and bidding firms is publicly known, if several potential
bidding firms can all obtain this cash flow, and if semi-strong capital
market efficiency holds (Fama 1970), then shareholders of bidding firms
will, at best, gain only competitive parity from acquisitions. In this setting
a ‘strategically related’ merger or acquisition may create economic value,
but this value will be distributed in the form of superior returns to the
shareholders of target firms. This conclusion follows directly from the
equilibrium expected in perfectly competitive markets (Hirshleifer 1980),
in this case the market for corporate control (Jensen and Ruback 1983).
The price of a target firm in such markets will rapidly rise to its NPV in
creating synergies with bidding firms, that is, k will tend to 0. The price of a
target will not be less than this level, for if it were, another bidder, seeing
an opportunity for superior returns, would drive the price up (Barney
1986a).2 Bidding firms that complete a merger or acquisition in this setting
will not obtain superior returns, even if they are completely successful
in exploiting anticipated relatedness with a target, for the value of that
relatedness will be reflected in the price of a target (Barney 1986a), and
thus distributed as superior returns to the shareholders of acquired target
firms.3
Different bidding firms may have different types of relatedness with tar-
get firms, and these competitive dynamics still unfold. All that is required is
that these different bidding firms value targets at the same level. However,
in real markets for corporate control, it seems likely that when different
bidding firms value the acquisition of targets at the same level, the type
of relatedness that exists between one bidder and targets is likely to be
quite similar to the type of relatedness that exists between other bidders
MERGERS AND ACQUISITIONS 209

and targets.4 This homogeneity in relatedness leads to a homogeneity in


the valuation of targets, which in turn leads to zero economic profits for
bidders on acquisition.
The frequency with which markets for corporate control are perfectly
competitive in this manner is ultimately an empirical question. However,
in general these conditions seem at least plausible. It is not difficult to
imagine a set of similar firms pursuing the same strategy in an industry
all becoming interested in a particular type of acquisition to implement
that strategy. In this setting, perfect competition dynamics are likely to
unfold, and firms that successfully acquire a target are likely to earn zero
economic profits for their shareholders. In all likelihood the manager who
successfully ‘snatches’ a target from several competing firms will have paid
a price for that target that fully anticipates any competitive advantages
associated with that acquisition. Such acquisitions cannot be expected to
generate superior returns for the shareholders of this successful bidding
firm.
Empirically, Ruback’s analysis (1982) of DuPont’s takeover of Conoco
suggests that this acquisition probably occurred in a perfectly competitive
market. Also, Singh and Montgomery’s research (1987), which showed
that strategically related acquisitions created more economic value than
unrelated acquisitions, but that this value was captured by the shareholders
of acquired firms, suggests that these acquisitions occurred in perfectly
competitive markets.

Superior returns to bidding firms from acquiring


related targets

Thus the existence of bidder and target relatedness, per se, is not a source
of superior returns to the shareholders of bidding firms. However, if a
market for corporate control is imperfectly competitive, then bidding firms
may be able to obtain a superior return for shareholders from imple-
menting merger and acquisition strategies. Three ways that these markets
can be imperfectly competitive—including (a) when private and uniquely
valuable cash flows exist between a bidder and target, (b) when inim-
itable and uniquely valuable cash flows exist between a bidder and target,
and (c ) when unexpected synergistic cash flows exist between a bidder
210 RBT AND ORGANIZATIONAL STRATEGIES

and target—are examined below. The first two of these cash flows reflect
valuable, rare and private and valuable, rare, and costly to imitate resources
controlled by bidding firms.

PRIVATE AND UNIQUELY VALUABLE SYNERGISTIC CASH FLOWS


One way such an imperfectly competitive market could exist is when a tar-
get is worth more to one bidder than it is to any other bidders—and when
no other firms, including bidders and targets, are aware of this additional
value. The price of a target will rise to reflect public expectations about the
value of a target. Once acquired, however, the performance of this special
bidder will be greater than expected, and this will generate superior returns
for its shareholders.
Consider, for example, the simplest case where the combined cash flow
between bidder A and target firms has an NPV of $12,000, whereas the
combined cash flows of all other bidders and targets have an NPV of
$10,000. Suppose also that, while no other firms are aware of A’s unique
status, they are aware of the value of the cash flow of all other bidders
combined with targets (i.e. $10,000). If the current cash flow of all bid-
ders has an NPV of $5,000, then firm A will obtain a superior return
from acquiring a target if it pays less than $7,000 (P = $12,000 − $5,000),
while all other bidders will obtain a superior return from acquiring a
target if they pay less than $5,000 (P = $10,000 − $5,000). All publicly
available information in this market suggests that a target is worth $5,000.
Thus, the price of targets will rise to this level, ensuring that if bidding
firms, besides firm A, acquire a target, they will not obtain superior
returns.
If there is only one target in this market for corporate control, then firm
A will be able to bid $5,000 + ε, that is, just slightly more than any other
bidder, to obtain the target. At this level, firm A obtains a superior return of
($7,000 − ($5,000 + ε)), that is, the added value of the combined cash flow
minus the price of obtaining that additional cash flow. No other firm will
bid higher than firm A because, from these firms’ point of view, the acqui-
sition is simply not worth more than $5,000. If there are several targets in
this market for corporate control, then firm A, along with several other
bidding firms, will all pay $5,000 for a target. While all other successful
MERGERS AND ACQUISITIONS 211

bidding firms will not obtain superior returns from their bidding activities,
firm A will obtain a $2,000 economic profit.
For firm A to obtain this return, the existence of its uniquely valuable
synergistic cash flows with targets cannot be known by other firms, both
bidders and targets. If other bidding firms know about this additional
value associated with acquiring a target, they are likely to try to dupli-
cate this value for themselves. Typically, this would be accomplished by
other firms duplicating the type of relatedness that exists between A and
targets by acquiring the resources and capabilities that create technical
economies, pecuniary economies, diversification economies, or some com-
bination of these types of relatedness between A and targets. Once other
bidders acquired the resources and capabilities necessary to obtain this
more valuable combined cash flow with targets, they would be able to
enter into bidding, thereby increasing the likelihood that the shareholders
of successful bidding firms would earn zero economic profits.
The acquisition of these resources and capabilities would not even have
to be completed before bidding began, because bidding firms can anticipate
that they will be able to acquire them at some point in the future, and
thus the NPV of the expected combined cash flow with a target for these
bidders is the same as for A (Barney 1986a). In this setting the price of
an acquisition will rise to the point where k = 0. Firm A is shielded from
this perfect competition if other bidding firms are unaware of the higher
synergistic cash flow available to A and the sources of this higher synergistic
cash flow (Lippman and Rumelt 1982).
Target firms must also be unaware of A’s uniquely valuable synergistic
cash flow for A to obtain superior returns from a merger or acquisi-
tion. If target firms are aware of this cash flow and its sources, they can
inform other bidding firms. These bidding firms could then adjust their
bids to reflect this higher value, and the competitive dynamics discussed
previously would reduce superior returns obtained by bidders to a fully
competitive level. Target firms are likely to inform bidding firms in this way
because increasing the number of bidders with a more valuable combined
cash flow increases the likelihood that target firms will extract all the eco-
nomic value created in a merger or acquisition (Jensen and Ruback 1983;
Turk 1987). Although there may be many different managerial motives
behind target firms seeking out ‘white knights’ as alternative merger part-
ners after an acquisition attempt has been made, the effect of such actions
212 RBT AND ORGANIZATIONAL STRATEGIES

Table 10.1. NPV of synergistic cash flows and NPV of four idiosyncratic
bidding firms ($)

Firm A Firm B Firm C Firm D

NPV of synergistic cash flows with targets 12,000 11,000 10,000 9,000
NPV of independent cash flows 3,000 5,000 3,000 2,000

is to increase the number of fully informed bidders for a target. This, in


turn, reduces the superior returns that successful bidding firms obtain.
Thus far, it has been assumed that only one firm had a more valuable
combined cash flow with targets (in the example, worth $12,000). How-
ever, the argument also applies to the more complex case when several
firms have combined cash flows with targets greater than what is publicly
known. As long as the number of targets is greater than or equal to the
number of firms with these more valuable combined cash flows, each of
these bidding firms can complete an acquisition, and each can earn varying
amounts of superior returns (depending on the value of each of these
bidding firm’s combined cash flows) for their shareholders.
The impact of private and uniquely valuable synergistic cash flows on
superior returns for shareholders of bidding firms even holds when differ-
ent bidding firms all have different independent cash flows, and when they
all have different combined cash flows with targets, that is, where each firm
acting in a market for corporate control is unique. Consider the example
outlined in Table 10.1. The NPV of the cash flows of firms A, B, C, and D in
this table vary from $5,000 to $2,000, and the NPV of the combined cash
flows with targets range from $12,000 to $9,000. From equation (10.2) it is
clear that firm A must pay less than $9,000 for a target to obtain superior
returns, firm B less than $6,000, firm C less than $7,000, and firm D less
than $7,000.
If information is publicly available suggesting that firms with the right
resources and capabilities can obtain an incremental growth in cash flow
worth $7,000 from acquiring a target, then several things are likely to occur.
First, firm B is likely to add to its resources and capabilities those attributes
that allow firms C and D to obtain a $7,000 NPV increase from acquiring
a target. Next, the price of a target is likely to rise to $7,000. If there are sev-
eral target firms available, all the firms in Table 10.1 will be able to acquire a
target, but only firm A will make a superior return (equal to $2,000). If only
MERGERS AND ACQUISITIONS 213

one target is available, only firm A will complete the acquisition or merger,
and its abnormal return, though still positive, will be slightly smaller
($2,000 − ε). If there are not enough targets for all bidding firms, then
which firms (B, C, or D) will complete an acquisition is indeterminate,
although whichever of these firms does will not obtain a superior return.
In this case, as well, firm A will complete an acquisition and still earn a
superior return for its shareholders equal, in total, to $2,000 − ε.
Adding a fifth firm (firm E) that is identical to firm A in Table 10.1
highlights the requirement that the number of firms with a more valuable
synergy with targets must be less than or equal to the number of targets in
order for these bidding firms to obtain superior returns. If there are two or
more targets, then both firms A and E can execute an acquisition for such
returns. However, if there is only one target, then firms A and E are likely
to engage in competitive bidding, perhaps driving the price of this target
up to the point where k = 0 (i.e. to $9,000) and in this process shifting
superior returns from their shareholders to the shareholders of acquired
firms.

INIMITABLE AND UNIQUELY VALUABLE SYNERGISTIC CASH FLOWS


The existence of a firm with private and uniquely valuable synergistic
cash flows with targets is not the only way that a market for corporate
control can be imperfectly competitive. If other bidders cannot duplicate
the uniquely valuable combined cash flow of one bidder and targets, then
competition in this market for corporate control will be imperfect, and the
shareholders of this unique bidding firm will earn superior returns. In this
case the existence of uniquely valuable combined cash flows does not need
to be private, for other bidding firms cannot duplicate these cash flows,
and thus bids that substantially reduce returns to the shareholders of this
special bidding firm are not forthcoming.
Typically, other bidding firms will be unable to duplicate the uniquely
valuable combined cash flow of one bidder and targets when the relat-
edness between this bidder and targets stems from some nonimitable
resources or capabilities controlled by this bidding firm. Such resources
and capabilities tend to be path dependent, causally ambiguous, socially
complex, or have other attributes that increase the cost of their imitation
214 RBT AND ORGANIZATIONAL STRATEGIES

identified in the resource-based literature (Dierickx and Cool 1989; Barney


1991a). Barney (1986b) has given several examples of inimitable resources
and capabilities, including a firm’s culture, its unique history, its product
reputation, etc. If any of these resources and capabilities are rare and, when
combined with a target, generate a more valuable cash flow than any other
bidders can obtain when combined with a target, then the shareholders
of these firms will obtain superior returns from acquisitions. This would
occur even if all firms in this market for corporate control were aware
of this more valuable synergistic cash flow and its sources. This superior
return will not be obtained by the shareholders of target firms because
competitive bidding dynamics cannot unfold when the sources of a more
valuable synergistic cash flow are inimitable.
As before, the number of firms with this special synergistic cash flow
with targets must be less than the number of targets for the shareholders of
these firms to obtain superior returns. If there are more of these special
bidders than there are targets, then these firms are likely to engage in
competitive bidding for targets, once again shifting superior returns from
bidding to target firm shareholders.
If the number of bidding firms with these special attributes is less than
the number of target firms, then these bidding firms enjoy some of the
advantages of a monopolist, and the level of superior return they obtain
will be approximately the same as for bidding firms with private and
uniquely valuable synergies. However, if the number of special bidders and
number of targets are the same, the market for corporate control takes
on many of the attributes of a bilateral monopoly. In this setting, the
level of return obtained by shareholders of bidding firms depends on their
negotiating skill (Hirshleifer 1980), and is thus indeterminant. When all
bidders and targets know the value of a target for a particular bidder, this
negotiated price is likely to fall somewhere between the value of targets for
firms with the highest value combined cash flows and the value of targets
for other bidding firms.
Of course, it may be possible for a unique and inimitable synergistic
cash flow to also be private. Indeed, it is often the case that those attributes
of a firm that are inimitable are also difficult to describe (Barney 1991b),
and thus can be held as proprietary information. In this case the analysis of
superior returns associated with unique and valuable synergistic cash flows
presented earlier applies.
MERGERS AND ACQUISITIONS 215

UNEXPECTED SYNERGISTIC CASH FLOWS


The analysis thus far has adopted, for convenience, the strong assumption
that the NPV of synergistic cash flows between bidders and targets are
known with certainty by individual bidders. This is, in principle, possi-
ble, but certainly not likely. Most acquisitions and mergers are massively
complex (Jensen and Ruback 1983), involving numerous unknown and
complicated relationships between firms (Ruback 1982). In these settings,
unexpected events may occur after an acquisition has been completed,
making the synergistic cash flow from an acquisition or merger more
valuable than what was anticipated by bidders and targets. The price that
bidding firms will pay to acquire a target will only equal the expected value
of that target when it is combined with the bidder. The difference between
the unexpected synergistic cash flow actually obtained by a bidder and
the price the bidder paid for the acquisition is a superior return for the
shareholders of this bidding firm.
Of course, by definition, bidding firms cannot expect to obtain unex-
pected synergistic cash flows. Unexpected synergistic cash flows, in this
sense, are surprises, a manifestation of a firm’s good luck, not its skill in
acquiring targets (Barney 1986a).

Implications for research on mergers and acquisitions

This discussion has several important implications for research on merg-


ers and acquisitions. First, the analysis suggests that much of the work
on mergers and acquisitions has been conducted at too aggregate a level
to inform managers of bidding firms when these strategies will generate
superior returns for their shareholders (Halpern 1983). This is true even
for research that has investigated the link between strategic relatedness
in a merger or acquisition and returns to shareholders of bidding firms.
Relatedness, per se, does not generate superior returns for bidding firms.
Rather, synergistic cash flows stemming from relatedness will lead to supe-
rior returns for shareholders of bidding firms when those cash flows are
private and unique, inimitable and unique, or unexpected. These cash
flows, in turn, will be generated by rare and private resources, or rare and
costly to imitate resources and capabilities controlled by bidding firms that
216 RBT AND ORGANIZATIONAL STRATEGIES

create economic value when combined with the resources and capabilities
of target firms. Future research will need to partition related mergers and
acquisitions into these much finer categories in order to study how strate-
gic relatedness is translated into superior returns for the shareholders of
bidding firms.
Second, the role of unexpected synergistic cash flows in generating supe-
rior returns for bidding firm shareholders from mergers and acquisitions
reemphasizes the role of luck in studying returns to the strategic actions of
firms (Lippman and Rumelt 1982; Barney 1986a). While luck is a difficult
variable to work with, especially in prescriptive models of competitive
strategy, its continued emergence in analytical work suggests its impor-
tance. Simply observing that an acquisition generated superior returns for
the shareholders of a bidding firm does not imply that a uniquely valuable
synergistic cash flow existed between this bidder and the acquired target.
Nor do such returns necessarily imply that managers in this firm are skilled
in discovering or exploiting relatedness between themselves and targets.
Bidding firms can simply be lucky.
Finally, the impact that managerial actions in bidding and target firms
can have on the distribution of the value created in a related acquisition
deserves further attention. It has already been shown in the literature that
target firms can obtain superior returns for their shareholders by increas-
ing the number of well-informed bidders (Jensen and Ruback 1983; Turk
1987). This process can be short-circuited if managers in bidding firms are
able to keep the existence of a uniquely valuable synergistic cash flow with
targets private. How managers in bidding firms might be able to keep this
information private (McKelvey 1982), and the implications of this private
information for the regulation of securities markets (Bettis 1983), deserve
ongoing attention.

Implications for practice

The arguments presented here also have important implications for man-
agers seeking to implement merger and acquisition strategies. First, while
the conditions under which these strategies will generate average and supe-
rior returns have been emphasized, this analysis also suggests that mergers
and acquisitions can lead to below average returns for the shareholders of
MERGERS AND ACQUISITIONS 217

successful bidding firms. This will occur when bidding firms overestimate
the value of targets, and thus the price paid for a target will be greater
than the economic value that a target brings to the bidding firm. Research
by Salter and Weinhold (1979), and others, suggests that bidding firms
typically overestimate the value of targets by underestimating the costs of
exploiting synergies with targets. Even when markets for corporate control
are imperfectly competitive, such miscalculations can generate economic
losses for successful bidding firms. To avoid these miscalculations, bidding
firms must become very skilled at understanding the nature of the strategic
relatedness between themselves and target firms. With this understanding,
bidding firms reduce the likelihood of overestimating the value of targets,
and increase the likelihood of gaining at least competitive parity from
mergers or acquisitions.
To move beyond competitive parity, the arguments presented here
suggest that bidding firms must develop a second skill, over and above
the ability to evaluate relatedness between themselves and targets. This
second skill is the ability of a bidding firm to understand and value
strategic relatedness between other bidding firms and targets. Firms can-
not expect to obtain superior returns from acquiring targets when sev-
eral other bidding firms all value these targets in the same way. In
these kinds of markets for corporate control, perfect competition dynam-
ics are likely to unfold, and the economic value of a target in creat-
ing competitive advantages for a bidding firm is likely to be reflected
in the price that a bidding firm must pay for a target. Thus, in order
to obtain expected superior returns from acquisitions, firms must com-
plete acquisitions only in imperfectly competitive markets for corporate
control.
Distinguishing between perfectly competitive and imperfectly compet-
itive markets depends on the ability of a firm to value the relatedness of
other bidders with targets, and compare that value with their own relat-
edness with a target. If other bidders value the target in the same way as
a particular firm does, perfect competition dynamics are likely to unfold,
and successful bidding firms can only expect zero economic profits. If other
bidders value the target at a lower level than a particular bidder, then this
peculiar bidding firm may earn superior returns from acquiring the target.
To earn expected superior returns from acquisitions, it is not enough for
managers to be good at spotting and valuing relatedness between their own
218 RBT AND ORGANIZATIONAL STRATEGIES

firm and targets; they must also be good at spotting and valuing relatedness
between other firms and targets.

NOTES

1. To simplify the discussion, it is assumed throughout the chapter that cash flows are
net of any transactions costs. Equation (10.2) also generalizes to the case where bidder
and target firms are not related. In this case, P is simply the NPV of the target, a
conclusion consistent with theory in finance (Copeland and Weston 1983).
2. Semistrong capital market efficiency implies that potential bidding firms will have
sufficient capital to engage in bidding, for as long as k < 0, an acquisition investment
will have a positive net present value (Fama 1970).
3. The lack of actual multiple bids for a target does not imply that perfect competition
does not exist. A bidding firm, in anticipation of other potential bidders, may make
an initial bid where k is equal to 0, or even larger than 0. In this case the threat of
anticipated competition for a target leads to zero economic profits for the sharehold-
ers of bidding firms completing an acquisition (Barney 1986a).
4. This assumption has recently been relaxed in a working paper being developed by
Rich Makadok and Russ Coff at Emory University. The results are generally consistent
with the arguments developed here.
Part IV
RBT: The Research
Frontier
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11 Resource-based
theory: empirical
research∗

In 1916, Albert Einstein predicted the existence of gravity waves. Given how
small these waves were supposed to be—10−18 of a millimeter—Einstein
was convinced that this implication of his general theory of relativity would
never be examined directly. Initially, the existence of these waves was only
examined indirectly, by observing that pulsars were losing mass at a rate
consistent with the existence of gravity waves. However, more recently, a
new generation of wave detection technology has been introduced. Draw-
ing on the computing power of thousands of personal computers linked
in a voluntary network, physicists now believe that it may be possible to
directly observe gravity waves, though it may take many years to refine the
technology and complete the data analysis (Lafferty 2005).
Godfrey and Hill (1995) observed that resource-based theory—along
with TCE and agency theory—incorporated difficult to observe concepts as
independent variables. These authors wondered if it would ever be possible
to directly test resource-based theory. Initially, they reasoned, resource-
based empirical work would have to focus on examining the observable
implications of a firm’s resources and capabilities, rather than examining
those resources directly. However, more recently, several scholars have
begun to develop techniques for measuring at least some aspects of these
previously difficult to observe concepts. Although it may take many years to
refine this measurement technology and complete the data analysis, there
is now a growing belief that it may be possible to measure resources and
capabilities and therefore to directly test the implications of resource-based
theory (Dutta, Narasimhan, and Rajiv 2005).

∗ This chapter draws from Barney and Arikan (2001) and Barney and Mackey (2005).
222 RBT: THE RESEARCH FRONTIER

In reviewing these stories, in no way is it being suggested that resource-


based theory has the same theoretical status as Einstein’s theory of general
relativity. Rather, these stories are reviewed only to point out that the
evolution of science—whether it is experimental physics or empirical social
science—often involves the development of new approaches to measure-
ment and testing that make what were once impossible to test theories
testable. Indeed, in the ever-growing literature that now constitutes the
‘resource-based view’, a great deal has been learned over the last several
years about how to test this theory (Barney and Arikan 2001). The purpose
of this chapter is to highlight some of these lessons.

Testing resource-based theory

Resource-based theory makes a few central assumptions about the nature


of resources and capabilities, their impact on a firm’s performance, and
the sustainability of these performance differences. These assumptions help
define the kinds of empirical work that is required to test resource-based
theory.

THE QUESTION OF VALUE


It is now widely understood that resources—the tangible and intangi-
ble assets controlled by a firm that enable it to create and implement
strategies (Barney 2002)—only have the potential to generate economic
value if they are used to do something (Porter 1991). Of course, the thing
that resources—and their close conceptual cousin, capabilities (Amit and
Schoemaker 1993)—are supposed to do is to enable firms to create and
implement strategies.
This simple insight actually suggests a way that researchers can measure
the potential of a firm’s resources to create value: To measure this potential,
measure the value created by the strategies a firm creates and implements
using its resources. Put differently, since resources have no value in and
of themselves and only create value when they are used to implement
strategies, researchers should examine the value these strategies create to
infer the potential value of a firm’s resources.
EMPIRICAL RESEARCH 223

Of course, there is substantial literature that describes the ability of dif-


ferent strategies to create economic value. A wide variety of such strategies
have been described, including cost leadership, product differentiation,
vertical integration, flexibility, tacit collusion, strategic alliances, corporate
diversification, mergers and acquisitions, and international strategies, to
name just a few (Barney 2002). Much of this work identifies the con-
ditions under which these strategies will and will not create economic
value.
For example, a cost leadership strategy creates value if and only if it
enables a firm to reduce its costs below those of competing firms (Porter
1980). A product differentiation strategy creates value if and only if it
enables a firm to charge higher prices for its products than a firm that is
not differentiating its products (Porter 1980). A corporate diversification
strategy creates value if and only if it exploits an economy of scope that
cannot be realized through market contracting (Teece 1980).
There has been less work that links specific firm resources and capabili-
ties with the ability to create and implement these kinds of firm strategies.
This is largely because currently available typologies of firm resources are
very broad in scope, for example, Barney’s distinction (2002) between
financial, physical, human, and organizational resources. Further work
developing this type of typology is likely to facilitate the examination of
the link between resources, in general, and the ability to conceive of and
implement specific strategies.
However, that there has been limited work that links specific resources
to particular strategies does not mean that there has been no work in this
area. Indeed, several papers have examined the linkages between partic-
ular resources and capabilities and specific strategies. Most of this work
is carried out on a limited sample of firms within a single industry. This
helps establish the link between the resources and strategies in question.
But, taken as a whole, this work suggests an approach to linking resources
to strategy and thereby examining the potential of resources to create eco-
nomic value by enabling firms to create and implement strategies. Consider
a couple of examples of this research.
In 1994, Henderson and Cockburn were interested in understanding
why some pharmaceutical firms were more effective in developing new
patentable drugs than other pharmaceutical firms. It is well known that
patents are a source of economic value in the pharmaceutical industry
224 RBT: THE RESEARCH FRONTIER

(Mansfield, Schwartz, and Wagner 1981)—contingent on the demand for


particular drugs, firms with large numbers of patented drugs will usually
have higher revenues than firms with smaller numbers of patented drugs.
The specific resource that Henderson and Cockburn were able to iden-
tify that enabled some firms to have more patents than other firms was
something they called ‘architectural competence’—the ability to facilitate
cooperation among the different scientific disciplines required to develop
and test a new pharmaceutical drug. Firms with high levels of this compe-
tence were able to patent more drugs than firms with low levels of this
competence. Henderson and Cockburn’s research showed that architec-
tural competence had the potential to generate economic value when it
was used to develop new patentable drugs.
More recently, Ray, Barney, and Muhanna (2004) examined the relation-
ship between the ability of two functional areas—the IT function and the
customer service function—and the level of customer service in a sample
of North American insurance companies. Again, it is widely recognized
that customer service is an information intensive function in most mod-
ern insurance companies, and that the careful use of IT can enhance the
ability of customer service professionals to meet their customers’ needs.
Customer satisfaction, in turn, is related to a variety of economically
important variables, including customer retention. What Ray, Barney, and
Muhanna (2004) were able to do is to develop a measure of the level of
cooperation between the IT and customer service functions in a sample of
insurance firms and demonstrate that this relationship—a socially complex
resource—has the potential to create economic value when it is used to
develop customer service-specific IT applications.
Besides demonstrating that it is possible to examine the potential of a
resource to create economic value by examining the value consequences
of the strategies a firm creates and implements by using these resources,
these—and related—papers have several other things in common. First,
they are examples of what might be called ‘quantitative case studies’. That
is, they examined the relationship between a firm’s resources and the
value of its strategies in a narrow sample of firms, typically a sample of
firms drawn from a single industry. This enabled these authors to clearly
identify industry-specific resources and capabilities and to build industry-
specific measures of these resources. Then, using traditional quantitative
techniques, they examined the relationship between these measures of
EMPIRICAL RESEARCH 225

firm resources and attributes of a firm correlated with a firm’s economic


performance.
Of course, it is difficult to generalize this research beyond the specific
industry contexts within which it is done. That architectural competence
is related to the number of patents in pharmaceutical firms may or may
not say anything about the relationship between architectural competence
and innovation in other firms in other industries. That the level of coop-
eration between IT and customer service has an impact on the level of
customer service in North American insurance companies may or may not
say anything about the relationship between this type of cooperation and
customer service in other firms in other industries.
Although these papers have limited generality at the level of the spe-
cific resources and strategies studied, their results are quite general from
a broader perspective. Each of these papers—and the several others that
apply a similar empirical logic (e.g. Combs and Ketchen 1999)—show that
at least some firm resources have the potential to generate economic value
if they are used to create and implement certain strategies. Over time, as
more of these quantitative case studies are done, our ability to specify the
conditions under which resources can be used to create and implement
strategies that create economic value will be enhanced.
Second, many of these studies examine the value potential of a firm’s
resources at a level of analysis below that of the firm. Not surprisingly, the
most correct level of analysis at which to examine the relationship between
a firm’s resources and its strategies is at the level of the resource, not the
level of the firm. However, the firm is usually the unit of accrual. We are
likely to learn a great deal more about the relationship between resources
and strategies if scholars are able to ‘get inside’ the firm, where resources
reside, rather than simply correlate aggregate measures of resources with
aggregate measures of the value of a firm’s strategies.
Finally, the central independent variables in both of these papers—
architectural competence in Henderson and Cockburn (1994) and
IT–customer service cooperation in Ray, Barney, and Muhanna (2004)—
focus on a particular type of organizational resource. This type of resource
has been described as socially complex (Barney 1991b), and it has been
linked to the sustainability of a firm’s competitive advantage. Empirically
examining these sustainability issues is examined in the next section of this
chapter.
226 RBT: THE RESEARCH FRONTIER

SUSTAINING COMPETITIVE ADVANTAGES


It is now widely understood that resources only have the potential to create
economic value, and that that potential is only realized when a firm uses its
resources to create and implement strategies. It is perhaps not as widely
recognized that the ability of other firms to imitate a particular firm’s
strategies does not depend on the attributes of those strategies, per se, but
rather on the attributes of the resources and capabilities that enabled that
firm to create and implement its strategies in the first place. Put differently,
just as resources only have the potential to create value through their
impact on a firm’s strategies, so too strategies only have the potential to
be costly to imitate because of the nature of the resources that enabled a
firm to choose and implement its strategies.
By their nature, strategies are relatively public. That is, when a firm
implements its strategies, it is usually not very long before other firms are
able to articulate what those strategies are. This is especially the case when a
firm’s strategies are logical and coherent.1 What are not always so public are
the resources and capabilities that enable a firm to create and implement
its strategies.
Resource-based theory suggests that valuable strategies that are created
and implemented using resources that are widely held or easy to imitate
cannot be a source of sustained competitive advantage (Barney 1991b). In
this context, a firm has a sustained competitive advantage when it is one
of only a few competing firms that is implementing a particular value-
creating strategy and when this competitive situation lasts over extended
periods.
Resource-based theory also makes specific predictions about the char-
acteristics of resources and capabilities that make some more difficult to
imitate than others.2 For example, Lippman and Rumelt (1982) suggest
that causally ambiguous resources are more likely to be costly to imitate
than resources that are not causally ambiguous. Barney (1986b) suggests
that resources and capabilities a firm already controls are more likely to be
costly to imitate than resources it acquires from competitive factor markets.
Barney (1986b) suggests that socially complex resources and capabilities—
the particular resource he examined in this paper was a firm’s culture—
are more likely to be costly to imitate than resources that are not socially
complex. Dierickx and Cool (1989) suggest that resources characterized
EMPIRICAL RESEARCH 227

by time compression diseconomies, asset stock interconnectedness, and


asset mass efficiencies are more likely to be costly to imitate than resources
without these attributes. Finally, in a summary, Barney (1991a) suggests
that path dependent, causally ambiguous, and socially complex resources
are more likely to be costly to imitate than resources without these
attributes.
Of course, each of these assertions implies testable hypotheses about
the imitability of different types of resources. A study that examined, say,
path dependent resources that enabled a few competing firms to create and
implement value-creating strategies, but where numerous firms were able
to imitate these strategies once they were initially implemented would be
very inconsistent with resource-based theory. So too would a study that
examined resources that did not possess any of these special attributes but
nevertheless enabled a few competing firms to create and implement value-
creating strategies, but where numerous firms were unable to imitate these
strategies once they were initially implemented. In the first study, path
dependence would not be a source of sustained competitive advantage; in
the latter case, the lack of path dependence (or social complexity, or causal
ambiguity, or some other attribute of resources supposed to prevent their
easy imitation) would be a source of sustained competitive advantage. Both
results contradict resource-based theory.
Of course, the empirical requirements to test these hypotheses are
nontrivial, but several studies have come close to approximating these
requirements. For example, by studying the resource-based determinants
of patents, Henderson and Cockburn (1994) come close to examining the
sustainability of any competitive advantages that architectural competence
might create because patents, as a function of patent law, last a defined and
relatively long period—twenty years.3
One particularly elegant study that examined the imitability of path-
dependent firm resources was published by Barnett, Greve, and Park
(1994). In this paper, Barnett, Greve, and Park examined why some com-
mercial banks competing in the state of Illinois during a recession were
able to outcompete other banks competing in the same market at the
same time. Clearly, banks that were not performing well in this setting
had a very strong incentive to imitate the strategies of banks that were
performing well. However, Barnett, Greve, and Park hypothesized that one
reason the strategies of the banks that were doing well were not subject
228 RBT: THE RESEARCH FRONTIER

to quick imitation was that these banks possessed resources and capabil-
ities that enabled them to choose these valuable strategies, and that these
underlying resources and capabilities were costly to imitate due to their
path dependent nature.
This study did not directly measure the resources that enabled some
banks to outperform other banks. However, it did demonstrate that banks
that had survived a financial recession previously, systematically out-
performed banks that had not survived a financial recession previously.
Barnett, Greve, and Park interpreted this finding to suggest that there was
something about the historical experience of banks that had survived a pre-
vious recession that equipped them with the resources and capabilities—
they use the largely interchangeable term ‘routines’ (Nelson and
Winter 1982)—necessary to survive, and even prosper, in a later reces-
sion. Of course, this paper would have been even stronger if it could have
directly measured these resources and the extent to which they were path
dependent in nature. Nevertheless, it is consistent with the general hypoth-
esis that path-dependent resources and capabilities are costly to imitate and
thus a source of sustained competitive advantage.
Makadok’s study (1999) of economies of scale in the money-market
mutual fund industry also supports resource-based assertions. In this case,
however, resource-based theory would suggest that since the realization of
these economies of scale did not depend on resources or capabilities that
are costly to imitate, that strategies that exploit these economies of scale
would not be a source of sustained competitive advantage for these firms.
If Makadok (1999) had found that economies of scale in this industry had
been a source of sustained competitive advantage, this would have been
inconsistent with resource-based theory.
Interestingly, these two studies, like the first two studies reviewed in this
chapter, are quantitative case studies. That is, they studied a sample of
firms drawn from a particular industry, and in the case of Barnett, Greve,
and Park (1994), from a particular geographic market. This enabled these
scholars to examine the link between specific resources, strategies, and
competitive advantage over time.
Unfortunately, neither of these studies measured the attributes of a
firm’s resources and capabilities directly. This is, perhaps, due to the dif-
ficulty of gaining access to this intraorganizational resource-level infor-
mation over an extended period. Obviously, duplicating Ray, Barney, and
EMPIRICAL RESEARCH 229

Muhanna’s survey methodology (2004) over several years would be very


challenging and would delay the publication of any subsequent paper
until after all the data had been collected. A recent paper by Leiblein
and Miller (2003) on transactions cost and resource-based implications
for vertical integration decisions comes closer to meeting this ideal stan-
dard than much of the previous work on sustainability of competitive
advantages.
Another attribute shared by these two studies is that they were con-
ducted on data over time. Although it is possible to define sustained
competitive advantage with respect to the observed inability of firms to
imitate a particular firm’s resources (Barney 1991a), this equilibrium def-
inition of sustained competitive advantage will often be highly correlated
with competitive advantages that last a long time. This suggests that time
series analyses of various kinds will generally be required to investigate the
imitability of different types of firm resources, and thus the sustainability
of a firm’s competitive advantage. The challenges associated with collect-
ing resource-level information within a firm over time have already been
discussed.

THE QUESTION OF ORGANIZATION


Thus, while much work is left to be done, some research has examined
what most consider to be the two central assertions of resource-based
theory: (a) that some resources have the potential to enable firms to create
and implement valuable strategies, and (b) that such resources can be a
source of sustained competitive advantage when they possess attributes
that make their imitation costly. However, some versions of resource-based
theory also suggest that firms must be organized to take advantage of their
resources and strategies if their full economic potential is to be realized
(Barney 2002). This emphasis on strategy implementation has received less
attention in the resource-based empirical literature.
There are several possible reasons for this relative inattention. First,
most strategy scholars are interested in understanding sources of sustained
competitive advantage. If a firm’s ability to implement strategies is valu-
able (in the sense described earlier), rare, and costly to imitate, then a
firm’s strategy implementation capability is a potential source of sustained
230 RBT: THE RESEARCH FRONTIER

competitive advantage. In this case, the study of strategy implementation—


as a source of sustained competitive advantage—is indistinguishable from
other studies of the sources of sustained competitive advantage.
Indeed, some of the studies reviewed thus far could easily be reinter-
preted as if they were examining the competitive consequences of a firm’s
ability to implement its strategies. Thus, Henderson and Cockburn’s study
(1994) could be reinterpreted as a strategy implementation study by sug-
gesting that architectural competence is the ability that some firms have to
implement their patenting strategies more effectively than other firms. In
this sense, because the ability to implement a strategy can be thought of
simply as another type of resource or capability, strategy implementation
can be thought of as just another possible source of sustained competitive
advantage.
This is one reason why research on the ability of firms to develop new
capabilities—so-called ‘dynamic capabilities’ (Teece, Pisano, and Shuen
1997)—has captured the interest of so many strategy scholars. Such
dynamic capabilities can also be reinterpreted in strategy implementation
terms: A dynamic capability is the ability that some firms have to create new
capabilities, capabilities whose potential value can only be realized when a
firm implements new strategies that build on these new capabilities.
However, another perspective on the question of organization is that
organization includes all those dimensions of implementing a firm’s strate-
gies that are, in principle, imitable, but are nevertheless important if a
firm is to gain competitive advantages. Barney (2002) calls these dimen-
sions of strategy implementation ‘complementary resources’, because these
implementation skills—things like an organization’s structure, its man-
agement controls, and its compensation policies—are not sources of
competitive advantage by themselves, but are nevertheless important
if a firm realizes the full competitive potential of its resources and
strategies.

Examples of resource-based empirical research

These principles about testing resource-based research have been applied


in a wide variety of disciplines, not just strategic management. The remain-
der of this chapter describes some of these tests.
EMPIRICAL RESEARCH 231

RESOURCE-BASED RESEARCH IN STRATEGIC MANAGEMENT


Not surprisingly, to date, strategic management scholars have conducted
the most empirical tests of resource-based logic. These tests examine sev-
eral important assertions derived from the theory, including: (a) that
firm effects should be more important than industry effects in deter-
mining firm performance, (b) that valuable, rare, and costly to imitate
resources should have a more positive impact on firm performance than
other kinds of resources, (c ) that corporate strategies (including mergers,
acquisitions, and diversification) that exploit valuable, rare, and costly to
imitate resources should generate greater returns than corporate strategies
that exploit other kinds of resources, (d) that international strategies that
exploit valuable, rare, and costly to imitate resources will outperform inter-
national strategies that exploit other kinds of resources, (e) that strategic
alliances that exploit valuable, rare, and costly to imitate resources will
outperform other kinds of alliances, and ( f ) that there cannot be a ‘rule
for riches’ derived from strategic management theory.

Industry versus firm effects on firm performance


Resource-based theory suggests that firm effects should have a larger
impact on firm performance than industry effects. The following research
examines the relative impact of industry attributes and firm attributes on
performance.
Initial work done by Schmalensee (1985) and Wernerfelt and Mont-
gomery (1988) on industry versus firm effects in explaining variance in
firm performance was inconsistent with resource-based expectations. In
particular, this work suggested that industry effects were more important
than firm effects. However, in 1991, Rumelt published an article that con-
tradicted these earlier findings. Rumelt (1991) argued that previous work
had applied the wrong methods or had used inadequate data to evaluate
the relative impact of industry and firm effects on firm performance. After
solving these problems, Rumelt’s results were consistent with resource-
based expectations. Several authors have replicated Rumelt’s results (e.g.
Brush and Bromiley 1997; McGahan and Porter 1997; Mauri and Michaels
1998). Some of these are critical of Rumelt’s findings, but primarily in
terms of the small corporate effect that Rumelt (1991) identified (Brush
232 RBT: THE RESEARCH FRONTIER

and Bromiley 1997). However, all these replications continue to document


that firm effects are a more important determinant of firm performance
than industry effects, although the relative size of these effects can vary by
industry.
Hansen and Wernerfelt (1989) found that firm factors explained about
twice as much variance in profit rates as economic factors. While Collis and
Montgomery (1995) reported that where a company chooses to play will
determine its profitability as much as its resources. According to Karago-
zoglu and Lindell (1998), motives behind internationalization of small and
medium-sized technology based firms can be explained more with firm-
specific characteristics rather than uniform patterns.
Other specific research on firm versus industry effects includes the influ-
ence of environmental conditions at founding on mortality rates (Swami-
nathan 1996), the impact of operating and competitive industry experi-
ence (Ingram and Baum 1997), and societal impacts on the acquisition
and creation of competencies (Marcus and Geffen 1998). Nickerson and
Silverman (1998) studied the buffering effect of high profitability in the
for hire trucking industry. Makadok (1998) examined sustainability of
first-mover and early-mover advantages in an industry with low barriers
to entry and imitation. In addition, proactive environmental strategy and
the development of competitively valuable organizational capabilities were
considered by Sharma and Vredenburg (1998), and the strategic impor-
tance of focusing on being different was studied by Deephouse (1999).

Resources and firm performance


Resource-based theory suggests that valuable, rare, and costly to imitate
resources can be sources of competitive advantage. This research examines
a variety of different resources that have these attributes to varying degrees
and examines their impact on performance.
The bulk of empirical resource-based work in the field of strategic man-
agement has focused on identifying resources that have the attributes that
resource-based theory predicts will be important for firm performance and
then examining whether the predicted performance effects exist. The per-
formance effects of a wide variety of different types of firm resources have
been examined, including a firm’s history (e.g. Collis 1991; Barnett, Greve,
and Park 1994; Rao 1994), employee know-how (e.g. Hall 1992, 1993;
Glunk and Wilderom 1998), its integrative capability (e.g. Henderson and
EMPIRICAL RESEARCH 233

Cockburn 1994), its innovativeness (e.g. Bates and Flynn 1995; McGrath
et al. 1996), its culture (e.g. Moingeon et al. 1998), and its network position
(e.g. Baum and Berta 1999; McEvily and Zaheer 1999), to name just a
few. A wide variety of different methods have been used to examine the
performance effects of firm resources including large sample surveys, small
sample surveys, case studies, and simulations. Overall, results are consis-
tent with resource-based expectations.
There are, however, a few studies that generate results that are inconsis-
tent with resource-based expectations. For example, Poppo and Zenger’s
analysis (1995) of vertical integration is more consistent with TCE than
resource-based theory. Also, Sherer, Rogovsky, and Wright (1998) do sug-
gest that compensation policy can have an effect on cooperation among a
firm’s employees, but that environmental conditions are a more important
determinant of this cooperation. These and similar results suggest that
the conditions under which different resources are and are not valuable
requires further development in resource-based theory (Priem and Butler
2001).
Further specific research on the impact of resources and capabilities on
firm performance includes the importance of the firm-specific knowledge
environment on process development (Pisano 1994), comprehension and
deftness within competence developing processes (McGrath, MacMillan,
and Venkataraman 1995), codifying and communicating manufacturing
capabilities (Zander and Kogut 1995), and contingent combinations of
firm-specific resources (Brush and Artz 1999). Miller and Shamsie (1996),
in their award-winning Strategic Management Journal paper, examined
the impacts of property-based and knowledge-based resources on perfor-
mance in the US film industry. Other knowledge-based research includes
studies of stocks and flows of organizational knowledge (De Carolis and
Deeds 1999), the negative impacts of nonlocal learning (Greve 1999),
integration of knowledge in product development (Hoopes and Postrel
1999), the transfer of intellectual property from universities to business
(Stevens and Bagby 1999), and team-based tacit knowledge in the National
Basketball Association (Berman, Down, and Hill 2002).
The role of firm resources and organizational attributes in determin-
ing entry timing was examined by Schoenecker and Cooper (1998).
Ruiz-Navarro (1998) focused on identification and acquisition of com-
plementary capabilities for a turnaround, and Maskell (1998) consid-
ered agglomeration of resources in low-tech manufacturing firms. Other
234 RBT: THE RESEARCH FRONTIER

researchers evaluated the performance impacts of TQM programs (Reed,


Lemark, and Montgomery 1996), appropriating and sustaining rents from
human capital (Maijoor and Wittrloostuijin 1996), top management and
organizational capital (Glunk and Wilderom 1998), organizational imped-
iments to innovation (Dougherty and Hardy 1996), and modes of interor-
ganizational imitation (Haunschild and Miner 1997). The integration of
environmental management concerns in strategic planning processes was
studied by Judge and Douglas (1998). Further resources and capabilities
that have been investigated include relational capabilities (Lorenzoni and
Lipparini 1999), corporate governance (McGuire 2000), localized learn-
ing (Maskell and Malmberg 1999), age dependence (Henderson 1999),
isolating mechanisms (Oktemgil, Greenley, and Broderick 2000), loca-
tion of airlines in their rival’s hub markets (Gimeno 1999), technological
competence and imitability (De Carolis 2003), and managerial foresight
associated with patenting breakthrough innovations (Ahuja, Coff, and
Lee 2005). While Yeoh and Roth (1999) investigated potential sources of
sustained competitive advantage in the pharmaceutical industry, Pettus
(2001) identified resource development paths in the deregulated trucking
industry. Douglas and Ryman (2003) found that service-related strategic
competencies were positively related to financial performance in the hos-
pital industry. Hansen, Perry, and Reese (2004) used a Bayesian hierarchical
methodology to examine the relationship between administrative decisions
and economic performance over time.

Resources and corporate strategies


Resource-based logic suggests that both tangible and intangible resources
can be important in corporate strategies, but only valuable, rare, costly
to imitate, and nonsubstitutable resources can be a source of sustained
competitive advantage for firms implementing merger, acquisition, and
diversification corporate strategies (as discussed in Chapters 9 and 10).
The impact of resources on corporate strategies and competitive advan-
tage has also been examined empirically. One of the most important
findings in this area is that SIC-code based measures of strategic relatedness
must be augmented by resource-based measures to capture the full perfor-
mance effects of diversification strategies (e.g. Robins and Wiersema 1995;
Farjoun 1998). Moreover, only when the basis of a diversification strategy
is valuable, rare, and costly to imitate can firms expect such a strategy
EMPIRICAL RESEARCH 235

to generate superior firm performance (Markides and Williamson 1996).


Moreover, while finance scholars have identified an important discount in
the value of firms when they begin to diversify (Lang and Stulz 1994),
resource-based theorists have shown that this discount either does not
exist or is consistent with shareholder’s interests when the characteristics
of the resources on which a firm’s diversification strategies are based are
accounted for (Miller 2000, 2004). Similar results have been found in
studies on the return to mergers and acquisitions (e.g. Coff 1999).
Further specific research on the impact of resources on corporate diver-
sification strategies includes differences in resource allocations between
target and acquiring firms (Harrison et al. 1991), consistency in resource
allocations (Harrison, Hall, and Nargundkar 1993), firm-specific factors
in multinational performance (Tallman 1991), firm-specific and product-
specific characteristics of service firms (Ingham and Thompson 1995), and
creating firm-specific advantage in a multinational subsidiary (Birkinshaw,
Hood, and Jonsson 1998). Resource deployment was examined in acqui-
sitions in declining industries (Anand and Singh 1997), following hori-
zontal acquisitions (Capron, Dussauge, and Mitchell 1998), in relation to
asset divestiture (Capron 1999), and market entry mode (Chatterjee and
Singh 1999). In addition, Silverman studied technological resources and
diversification decisions (Silverman 1999), and Gupta and Govindarajan
(2000) examined subsidiary knowledge stocks and transmission channels.
Miller (2004) found that the diversification discount observed ex post can
be explained in part by firms having lower levels of technological resources
ex ante. Carow, Heron, and Saxton (2004) examined early-mover advan-
tages in acquisitions and found that strategic pioneers experience posi-
tive acquisition announcement returns and outperform other acquirers
in acquisition waves in terms of long-term stock price as well. Shamsie,
Phelps, and Kuperman (2004) looked at performance differences among
late entrants in fifteen different new product categories of household elec-
trical equipment. They found that the ability of a late mover to penetrate
the market is strongly linked to its own resources (size and relevance) and
its own strategy.

International strategies
Resource-based work on international strategies is a logical extension of the
work on diversification strategies cited earlier. However, some attributes
236 RBT: THE RESEARCH FRONTIER

of resource-based arguments are highlighted in an international context.


For example, this work shows that a firm’s resources reflect its country of
origin and that these country differences are long lasting (e.g. Karnoe 1995;
Jarvenpaa and Leidner 1999). This work also examines the role of different
forms of governance in realizing cross-border economies of scope and
suggests that the tacitness of the resources used to realize these economies
is an important determinant of governance choices (e.g. Zou and Ozsomer
1999).
Further specific research on the role of resources in an interna-
tional context includes transferring idiosyncratic technologies (Kogut and
Zander 1992), international diversification (Hitt, Hoskisson, and Kim
1997; Geringer, Tallman, and Olsen 2000), top management team interna-
tional business advice network density (Athanassiou and Nigh 1999), the
intensity and diversity of host country experience (Luo and Peng 1999),
and expatriate staffing of subsidiaries (Gong 2003). Research on Japanese
firms examined product-specific competencies and market size (Arora and
Gambardella 1997), knowledge diffusion (Appleyard 1996), proprietary
assets (Delios and Beamish 1999), and firm strategies and the environment
(Kotha and Nair 1995). In addition, Mutinelli and Piscitello (1998) studied
skills and entry mode of Italian multinationals, Baldauf, Cravens, and
Wagner (2000) examined export performance in Austria, and Nachum and
Rolle (1999) considered firm-specific characteristics of advertising agencies
in the UK, France, and the United States. The impact of the international
experience of CEOs on the degree of internationalization and on financial
performance was also investigated by Daily, Certo, and Dalton (2000).
Financial implications of specificity and opacity of strategic resources were
studied using Spanish manufacturing firms (Vicente-Lorente 2001), and
RBV-driven variables were found to explain share values for Czech firms
in the privatization period when the capitalistic economy was emerging
(Makhija 2003).

Resources and strategic alliances


Closely related to resource-based international research is work that
focuses on the impact of resources of strategic alliances. In particular,
this work focuses on how firms can use alliances to either exploit their
preexisting resources or develop new resources. This latter work integrates
EMPIRICAL RESEARCH 237

insights from research on learning and absorptive capacity with resource-


based logic (e.g. Lane and Lubatkin 1998; Shenkar and Li 1999; Dussauge,
Garrette, and Mitchell 2000).
Further specific research on the role of resources in determining the
performance of strategic alliances includes functional expertise of man-
agement teams in high-tech ventures (McGee, Dowling, and Megginson
1995), R&D skill sharing (Sakakibara 1997), firm-specific technological
capabilities (Mowery, Oxley, and Silverman 1998), technical education and
experience of executives (Tyler and Steensma 1998), and intellectual prop-
erty rights (McGaughey, Liesch, and Poulson 2000). Combs and Ketchen
(1999) contrasted resource-based and organizational economics factors
on interfirm cooperation, while Gulati (1999) examined the impact of
prior alliances on decisions to enter new alliances. In addition, research
on international strategic alliances focused on multinational alliances in
China (Luo 1999), and international strategic partner selection (Hitt et al.
2000). Park, Mezias, and Song (2004) found that alliances of e-commerce
firms have a positive effect on firm value in an emerging business sector.

Rules for riches


Finally, resource-based logic suggests that it is not possible to deduce rules
for riches from strategic management theories, as persistent superior per-
formance depends on valuable, rare, and costly to imitate resources. Rules
for riches are rules that any firm can apply to gain sustained competitive
advantages and economic rents. In this empirical work, the impossibility
of deriving rules from riches from strategic management theory is exam-
ined in the context of the difficulty of sustaining competitive advantages
through the application of well-known, widely understood, managerial
practices. These include the use of reengineering (Walston, Burns, and
Kimberly 2000), learning curve logic (Lieberman 1982, 1987), the structure
of training programs (Segev, Raveh, and Farjoun 1999), formal long-range
planning (Brews and Hunt 1999), and patenting procedures (Mansfield,
Schwartz, and Wagner 1981; Mansfield 1985; Schankerman 1998). Difficul-
ties of focusing on a few competencies were investigated by Tripsas (1997)
and Miller and Toulouse (1998). In addition, Makadok (1999) found
that money-market mutual fund families with larger marginal returns to
increasing their scale subsequently do gain market share at the expense
238 RBT: THE RESEARCH FRONTIER

of their competitors, but this effect diminishes over time, possibly due to
imitation.

RESOURCE-BASED RESEARCH IN OTHER MANAGEMENT DISCIPLINES


While the bulk of empirical research on resource-based theory focuses
on strategic management implications of the theory, this theory has had
implications in related fields as well. Among the most important of
these is HRM (as discussed in Chapter 6). Several other disciplines have
begun to explore the empirical implications of resource-based logic. These
include marketing, entrepreneurship, management information systems
(MIS), operations management, and technology and innovation manage-
ment. While research approaches vary by discipline, in all these differ-
ent settings, research examines how various kinds of functional resources
affect firm performance in ways that are consistent with resource-based
logic.

Human resource management


Resource-based logic suggests that socially complex resources and capabili-
ties should be among the most important sources of sustained competitive
advantages for firms. Human resources are examples of socially complex
resources and thus it is not surprising that HR theorists have drawn heavily
on resource-based logic to examine the impact of human resources and
HR policies on firm performance (Wright and MacMahan 1992; Wright,
MacMahan, and McWilliams 1994; Barney and Wright 1998).
Some of the earliest work in this area focused on the impact of human
resources on cost and quality in manufacturing (Womack, Jones, and Roos
1990; MacDuffie 1995). More recently, this work has focused on various
bundles of HR practices that can have the effect of creating significant firm-
specific human capital investments (e.g. Huselid and Becker 1997; Harel
and Tzafrir 1999) and improving firm performance (Delaney and Huselid
1996). While some of this work has been criticized (Becker and Gerhart
1996), there is little doubt that resource-based logic has had an important
impact on human resources research.
Further specific research on human resources includes aligning HRM
practices to formulated strategy (Schuler and MacMillan 1984), aligning
EMPIRICAL RESEARCH 239

human capital enhancing HR systems and manufacturing strategies


(Youndt et al. 1996), and integrating the HR function with strategic
decision-making (Bennet, Ketchen, and Schultz 1998). Interestingly, Gupta
and Govindarajan (1984) found no consistent managerial characteristics
that would guarantee effective strategy implementation in multinationals.
Yet Richard (2000) found that cultural diversity adds value and contributes
to competitive advantage in the right context.
Huselid (1995) observed that investment in high performance work
practices reflected in lower employee turnover and greater productivity and
financial performance. Other studies examined HR management effective-
ness (Huselid, Jackson, and Schuler 1997), HR involvement in strategy and
perception of HR effectiveness (Wright et al. 1998), and the links between
strong employee commitment and generic strategies (Lee and Miller 1999).
Koch and McGrath (1996) examined labor productivity in capital intensive
firms, while Delery and Doty (1996) considered universal, contingency,
and configurational HR performance expectations. Both hard and soft
versions of HRM based on theories X and Y were investigated by Truss
et al. (1997).
Welbourne and Andrews (1996) examined the impact of HR value
and organization-based rewards on IPO performance; Klaas, McClendon,
and Gainey (1999) considered idiosyncratic HR practices moderating the
degree of outsourcing and perceived benefits; and Gainey and Klaas (2003)
looked at the impact of outsourcing of training and development on client
satisfaction. In addition, the effects of human capital and social capital on
firm dissolution were studied by Pennings, Lee, and van Witteloostuijn
(1998). The effects of human capital on the performance of large US law
firms were demonstrated by Hitt et al. (2001). Hatch and Dyer (2004)
examined human capital as a source of sustainable competitive advantage
in semiconductor manufacturing firms. Kor and Leblebici (2005) tested
the impacts of interdependencies between human capital deployment,
development, and diversification strategies on performance in professional
service firms. Employers’ participation in school-to-work programs was
shown to enable the development of firm-specific human capital capabili-
ties by Linnehan and De Carolis (2005).
Internationally focused research includes HR practices, HR outcomes,
and firm performance in Russia (Fey, Bjorkman, and Pavlovskaya 2000),
HR practices influencing high mobility of managers in Hong Kong (Field,
240 RBT: THE RESEARCH FRONTIER

Chan, and Akhtar 2000), and strategy–HRM interaction impacts on per-


formance in Singapore firms (Khatri 2000).

Marketing
The role of marketing resources as sources of competitive advan-
tage and their impacts on firm performance has been investigated by
many researchers. Specific marketing resources studied include market-
ing resources and capabilities from foreign direct investments (Hooley
et al. 1996), market based and marketing support resources (Hooley et al.
2003), technical knowledge assets enabling bundled products (Ghingold
and Johnson 1997), marketing mix reactions to a new entrant (Gatignon,
Robertson, and Fein 1997), market knowledge competence (Li and
Calantone 1998), industrial distribution channels (Johnson 1999), mar-
keting strategy-making process (Menon et al. 1999), corporate citizenship
in internal and external marketing (Maignan, Ferrell, and Hult 1999),
redeployment of marketing assets after acquisitions (Capron and Hulland
1999), media reputation (Deephouse 2000), and market orientation (Hult
and Ketchen 2001). In addition, Hult, Ketchen, and Slater (2004) exam-
ined market orientation using both cultural and information processing
elements and found that both approaches contribute to explaining per-
formance, but their effects are mediated by organizational responsiveness.
In a study of market dominance, Shamsie (2003) found that advantages
from reputation are tied to specific industry characteristics, for example
industries with consumer products that are purchased frequently and have
lower prices.

Entrepreneurship
Resource-based logic has also been applied empirically in the field of
entrepreneurship. Chrisman (1999) examined the resources and capabil-
ities influencing start-ups and regional differences in start-up propensities,
while Dean, Turner, and Bamford (1997) considered the factors assisting
the postentry phase for new firms. Other studies of small and entrepre-
neurial firms have focused on basic capabilities (Rangone 1999), as well as
firm-specific resources (Borch, Huse, and Senneseth 1999). The impact of
EMPIRICAL RESEARCH 241

resources on performance of small service and retail firms was examined


by Brush and Chaganti (1999), and Michael and Robbins (1998) focused
on retrenchment among small manufacturing firms during recession. In
addition, dynamic capabilities and new product development in high tech-
nology ventures were studied by Deeds, De Carolis, and Coombs (2000) in
their empirical analysis of biotechnology firms. Consistent with resource-
based theory, Choi and Shepherd (2004) found that entrepreneurs were
more likely to exploit opportunities when they perceived more knowl-
edge of customer demand for the product, more fully developed enabling
technologies, greater managerial capability, and greater stakeholder
support.

Management information systems


Strategic roles for resource and capabilities that are based on IT and MIS
have been considered by many IT–MIS scholars (as discussed in Chapter 7).
Among this research, there have been some empirical studies which have
applied resource-based logic. Dent-Micallef and Powell (1998) found that
IT investment per se had no effect on performance in the retail service
industry. However, when combined with intangible, difficult-to-imitate
complementary resources, such as a flexible culture, strategic planning, IT-
integration, and supplier relationships, retail firms gained a competitive
advantage. Similarly, Ray (2000), in his study of customer service processes
in North American insurance firms, found that firm-specific managerial
IT knowledge can be a source of sustainable competitive advantage (fur-
ther explained in Ray, Barney, and Muhanna 2004; Ray, Muhanna, and
Barney 2005). Bharadwaj (2000) found that firms with high IT capabil-
ity outperformed others in a matched sample group in his project that
focused on firm-specific IT resources including IT infrastructure, human
IT resources, and IT-enabled intangibles (such as customer orientation,
knowledge assets, and synergy). Li and Ye (1999) found that IT investments
linked to managerial, strategic, and environmental factors had a stronger
positive effect on financial performance. In addition, Broadbent, Weill,
and Neo (1999) examined IT infrastructure capabilities of firms linked to
their strategic context. Tippens and Sohi (2003) found that organizational
learning plays a significant role in mediating the effects of IT competency
242 RBT: THE RESEARCH FRONTIER

(comprising IT knowledge, IT operations, and IT objects) on firm perfor-


mance.

Operations management
Resource-based logic has also been applied empirically within the field
of operations management, with the same pattern of results as discussed
above with IT/MIS research. Powell (1995) found that TQM tools and tech-
niques do not generally produce competitive advantage, but certain tacit,
behavioral, imperfectly imitable features such as an open culture, employee
empowerment, and executive commitment can be a source of competitive
advantage. Knights and McNabe (1997) also examined quality focusing on
measurement issues. The alignment between best practices, processes, and
manufacturing strategy was investigated by Morita and Flynn (1997). In
addition, Klassen and Whybark (1999) studied the pattern of investments
in environmental technologies, manufacturing strategy, and performance
in the furniture industry. They found that significantly better performance
was achieved where management invested in the environmental technology
portfolio and allocated resources toward pollution prevention technolo-
gies. Hult, Ketchen, and Nichols (2002) examined the effects of supply
chain cultural competitiveness as a strategic resource which can improve
supply chain outcomes such as on order fulfillment cycle time. Finally,
in their study of manufacturing performance, Schroeder, Bates, and Junt-
tila (2002) focused on three manufacturing capabilities (internal learning,
external learning, and proprietary processes and equipment) and their
findings were consistent with resource-based theory.

Technology and innovation management


Resource-based logic has also been applied empirically within technol-
ogy and innovation management. Key findings here are consistent with
resource-based theory and research. In their study of the acquisition
of medical technological innovation and hospital performance, Irwin,
Hoffman, and Lamont (1998) found that the relationship is strongest
when these technological innovations are valuable, rare, and imperfectly
imitable. Similarly, Stuart and Podolny (1996) found that the evolution
EMPIRICAL RESEARCH 243

of technological positions is derived from firm-specific ability to innovate


in particular technological subfields that partly shapes their competitive
success. Intangible resources and capabilities were the main determinants
of profitability for Spanish firms engaged in internal R&D (Del Canto and
Gonzales, 1999). Further, Helfat (1997) found that dynamic capabilities
enabled firms to stay competitive through changing market conditions in
her study of knowledge and asset complementarity in R&D processes.
Other specific research within technology and innovation management
included projects on optimal patent policy and innovation (Chang 1995),
environmental pollution and competitive advantage in industrial goods
manufacturing firms (Morris 1997), and knowledge transfer between cus-
tomers and suppliers in industrial districts (Albino, Garavelli, and Schiuma
1999). Dutta, Narasimhan, and Rajiv (2005) used stochastic frontier esti-
mation to demonstrate heterogeneity in R&D capabilities in the semicon-
ductor industry.

Exemplars of resource-based research

Three of the articles cited above can be seen as exemplars of how resource-
based research can be done. Consider, for example, Henderson and Cock-
burn’s examination (1994) of the impact of ‘component competence’ and
architectural competence on the research productivity of pharmaceutical
firms. Henderson and Cockburn measure the value of these competencies
by estimating their impact on the research productivity of pharmaceutical
firms, under the assumption that pharmaceutical firms with more produc-
tive research efforts will outperform pharmaceutical firms with less pro-
ductive research efforts. They measure the rarity of these competencies by
showing that their level varies across competing pharmaceutical firms. And
they measure the imitability of these competencies by showing that firm
differences in the level of these competencies remain very stable over time.
To the extent that high levels of research productivity are valuable in the
pharmaceutical industry, Henderson and Cockburn’s results are consistent
with resource-based theory.
Makadok (1999) provides another paper that rigorously tests resource-
based theory. Makadok examines the impact of differential levels of
244 RBT: THE RESEARCH FRONTIER

economies of scale on the ability of money-market mutual funds to


increase their market share. Makadok measures the value of these
economies of scale by first estimating the impact of the size of a fam-
ily of funds on both its weighted-average risk-adjusted gross yield and
its weighted-average expense ratio and then shows that these yields and
expenses affect the market share of a family of funds. He measures the rarity
of economies of scale by showing that they vary across families of funds.
And he examines the imitability of these scale differences by examining
their impact on the market shares of families of funds over time. Consistent
with resource-based theories, because economies of scale are not path
dependent, causally ambiguous, or socially complex, Makadok does not
expect these capability differences to be a source of sustained competitive
advantage. And, in fact, the impact of scale differences on market share
becomes smaller over time—results that are again consistent with resource-
based theory.
Hatch and Dyer (2004) provide a third exemplar of resource-based
empirical research in their study of the impact of firm-specific investments
in human capital on learning-by-doing performance in the semiconductor
manufacturing industry. They measured the effects of preemployment
screening tests, HR training, deployment of human capital, and inim-
itability of human capital on learning-by-doing performance. Hatch and
Dyer found that firms using screening tests in their selection process were
able to more effectively identify employees with the ability to learn and
adapt to the new environment. Effective screening enabled firms to move
more quickly down the learning curve. Depth of human capital skills
was more valuable than breadth of capital skills (training on multiple
machines) in influencing learning performance. Firms with greater deploy-
ment of human capital to learning activities were able to realize learning
advantages. In addition, the importance of firm-specific human capital on
learning was demonstrated by showing that defects increased with newly
hired employees and as turnover increases. Consistent with resource-based
theory, Hatch and Dyer show that managing the selection, development,
and deployment of human capital can significantly improve learning-by-
doing and firm performance. Further, they provide empirical evidence that
rivals cannot quickly or costlessly imitate or substitute for the value of firm-
specific human capital.
EMPIRICAL RESEARCH 245

Conclusion

An overview of key empirical tests of resource-based theory conducted by


scholars within strategic management and other management disciplines
has been presented in this chapter. Collectively, these studies provide an
impressive and comprehensive body of empirical evidence of resource-
based theory. Further, the results demonstrate highly consistent findings
across the domain of strategy and all of these other management disci-
plines.
While the ability to operationalize and test resource-based theory has
been questioned (Priem and Butler 2001), there is now a significant body
of empirical work (as outlined in this chapter) which demonstrates conclu-
sively that resource-based theory can be tested. As resource-based theory
has become more widely accepted as a key perspective for research on firm
performance, the number of studies has grown markedly and resource-
based theory publications have steadily increased.
However, scholars continue to ask, ‘How does one measure resources?’
Usually, the question they are really asking is ‘How does one measure
resources easily?’ The answer is, of course, that you do not measure
resources easily. But as the empirical tests of resource-based theory con-
tinue to evolve, what becomes clear is that it is possible to derive testable
assertions from this theory and then to collect the data needed to test these
assertions.
In 1916, Einstein believed his theory of gravity waves could never be
tested. In 1995, Godfrey and Hill were also not optimistic about the testa-
bility of many of the central assertions of resource-based theory. It may well
be that both these predictions may turn out to be overly pessimistic.

NOTES

1. When firms implement a set of incoherent, self-contradictory strategies, it is often


difficult for competitors to know what exactly a firm intends to do. Of course, this is
often because this firm, itself, does not know exactly what it intends to do.
2. Recall that imitation can take two forms: direct duplication or substitution (Barney
2002). The arguments developed in this section apply most directly to direct
duplication. Further work is required to see if these same arguments apply to resource
substitution.
246 RBT: THE RESEARCH FRONTIER

3. Ray, Barney, and Muhanna (2004) try to finesse the sustainability question by arguing
that the North American insurance industry is a very mature industry and that the
relationship between IT and customer service is well known in the industry. In such a
setting, any remaining heterogeneity in the application of IT to the customer service
function must be the result of costly to imitate resources and capabilities possessed
by some firms but not others. However, because they have only cross-sectional data,
they obviously are unable to test this hypothesis directly.
12 The future of
resource-based
theory

This thing called resource-based theory has come a long way since the mid-
1980s, when it was first being formulated by Rumelt (1984), Wernerfelt
(1984), and Barney (1986a). Beginning with a small group of scholars,
resource-based theory grew rapidly until it arguably became the domi-
nant theory in the field of strategic management by the late 1990s. This
roughly fifteen-year period saw numerous refinements of the theory, many
empirical tests, and several pointed criticisms (e.g. Porter 1991; Priem and
Butler 2001; Bromiley 2005). But the central assertions of the theory—that
firms often possess different resources and capabilities, that these differ-
ent resources and capabilities enable some firms to implement valuable
strategies that other firms will find too costly to implement, and that
these differences among firms can be long lasting—remain pretty much
unchanged since its earliest development.
Given this history, a reasonable question becomes: What is next for
resource-based theory? Is it possible that this theory will continue to yield
new theoretical or empirical insights? If so, in what areas are these insights
likely to exist? Or, has this theory run its course, destined to being part of
the established base of theory in the field of strategic management, but no
longer inspiring new and creative theoretical and empirical work?
Of course, our belief is that resource-based theory has the potential
to continue to generate new theoretical and empirical insights. The pri-
mary purpose of this chapter is to describe some areas where this poten-
tial might be realized. However, before describing where these insights
are likely to come from, it might make sense to cite a few areas where
we think additional discussion and debate is not likely to generate new
insights.
248 RBT: THE RESEARCH FRONTIER

Issues that are no longer important

In the development of resource-based theory, a variety of issues have been


raised and addressed. While many of these questions have been important
in the refinement of this theory, and, in fact, are reflected in the summary
of resource-based theory presented in this book, in our view, some of these
questions are very unlikely to generate additional insights. Four of these
questions are discussed here.

ARE RESOURCES, CAPABILITIES, DYNAMIC CAPABILITIES,


AND SO FORTH DIFFERENT, AND DOES IT MATTER?
The definitions of resources provided in Wernerfelt (1984) and Barney
(1991a) are very broad—Wernerfelt talks of anything in a firm that could
be thought of as a strength, Barney includes anything controlled by a firm
that can enable it to implement strategies. These definitions were broad for
several reasons. First, these broad definitions made it clear that resource-
based theory was a broadly applicable theory, not just a ‘theory of the
middle range’ (Merton 1957). In this sense, both Wernerfelt and Barney
were trying to show that resource-based theory was at the same level of
generality as Porter’s positioning theory.
Second, a short list of ‘essential resources and capabilities that all firms
must possess to gain competitive advantages’ could easily have been mis-
interpreted as suggesting a ‘rules for riches’. Rather than focusing on the
ability of specific resources to generate competitive advantages, Barney
(1991a), Dierickx and Cool (1989), and Peteraf (1993) focused on the
attributes that a firm’s resources and capabilities must have to be a source
of sustained competitive advantage.
Finally, since at the time, very little empirical work on the relation-
ship between firm resources and performance had been conducted, it was
difficult to know which among all of the resources and capabilities con-
trolled by a firm might ultimately turn out to generate sustained compet-
itive advantages. Again, the theory described the kinds of attributes these
resources and capabilities would have—they would be, for example, path
dependent, causally ambiguous, and/or socially complex—but it did not
THE FUTURE OF RESOURCE-BASED THEORY 249

specify which specific resources a firm might control would be sources of


sustained competitive advantage.
While these broad definitions had their purpose, they were limited in
their ability to provide guidance for empirical research. They also made it
difficult to teach resource-based theory. In response, a variety of resource
typologies were introduced into the literature. Barney (1991a), for exam-
ple, suggested that firm resources might be physical capital, human capital,
or organization capital. Stalk, Evans, and Shulman (1992) distinguished
between resources and capabilities.
Note that the essential predictions of resource-based theory did not
change with the introduction of these typologies. That is, whether the
resources in question are labeled ‘resources’, ‘capabilities’, ‘organizational
capital’, and so on, the theory predicted that these firm assets were only
likely to be a source of sustained competitive advantage when they enabled
a firm to implement a strategy that increased the willingness of its cus-
tomers to pay and/or reduced its costs while simultaneously being path-
dependent, causally ambiguous, or socially complex in nature. All these
different labels did was parse the very large and unorganized space created
by the term ‘resources’ into a more organized space that could facilitate
empirical work and teaching. These labels, by themselves, did not change
the central propositions of resource-based theory.
Since these early efforts, there has been a proliferation of labels for the
resources controlled by a firm. Some of this proliferation has been helpful.
For example, Teece, Pisano, and Shuen (1997) labeled one kind of firm
resource ‘dynamic capabilities’ to focus attention on the ability of firms to
develop new capabilities as a source of sustained competitive advantage.
Several other authors have used the term ‘routine’ to refer to resources.
This helped draw an important connection between resource-based theory
and the evolutionary theory of the firm (Nelson and Winter 1982).
However, changing the label of the independent variable of a theory
does not change the central assumptions and assertions of that theory.
Thus, what makes resources a potential source of sustained competitive
advantage are the same as what make capabilities, dynamic capabilities,
routines, and so forth potential sources of sustained competitive advan-
tage. In this sense, resource-based theory is not really about resources,
per se, but about the attributes that resources must possess if they are to
250 RBT: THE RESEARCH FRONTIER

be a source of sustained competitive advantage. That this theory is called


‘Resource-based’ is something of an historical accident.1 It could just
as easily have been called ‘capability-based’ or ‘competence-based’—the
underlying theory would have remained the same.
One of the unfortunate consequences of this proliferation of labels of
the independent variables of this theory is that some have concluded that
changing the label means that the theory, itself, is changed, and thus
requires a new name. Thus, when knowledge is the independent variable in
the theory, the theory is called the ‘knowledge-based view’, when dynamic
capabilities is the independent variable in the theory, the theory is called
the ‘dynamic capabilities view’, and so forth.
Renaming the theory this way, even though the underlying causal
linkages between the independent variable in question and sustained
competitive advantage remains the same, is roughly equivalent to label-
ing transactions cost research that examines the relationship between
transaction-specific investment and governance as the ‘specific investments
view’ and transactions cost research that examines the relationship between
behavioral uncertainty and governance as the ‘uncertainty view’. These new
names fail to recognize that both of these ‘views’ apply the same underlying
logic about the relationship between opportunism and governance devel-
oped by Williamson (1975, 1985) and others. If the causal mechanisms
remain unchanged, the theory remains unchanged, even if the specific
independent variables change labels.
So, in our view, there likely are differences between resources, capa-
bilities, dynamic capabilities, routines, knowledge assets, and other labels
that have been used to describe the independent variables in this class
of theories. These fine distinctions may help in empirical tests of the theory.
They also can help in teaching. However, unless these different indepen-
dent variables change the nature of the logic that links a firm’s assets with
sustained competitive advantage, they are not actually new theories, but
rather, a manifestation of a more general theory. In this book, we have
called this theory ‘resource-based theory’—not because this is somehow
the ‘best’ label that could have been chosen, but because it was the first.
Additional names for this theory—including the knowledge-based view
or dynamic capabilities view—are only appropriate if these perspectives
develop and apply an alternative logic that links a firm’s assets and its
sustained competitive advantage.
THE FUTURE OF RESOURCE-BASED THEORY 251

CAN RESOURCES REALLY BE MEASURED?


Over the years, many students and faculty alike have asked the question:
How do I measure firm resources? Of course, what they are really asking
is: How do I measure firm resources easily? The answer to this second
question is: You don’t.
With regard to measurement, we have much better theories about how
not to measure resources than we do about how to measure resources. As
suggested by Godfrey and Hill (1995), the essential measurement task is to
insure that the independent variables in this theory are not measured by
the dependent variable, that is, that the value, rarity, and imitability of a
firm’s resource is not measured by a firm’s high level of performance.
Several critics of resource-based theory have suggested that this is a
common way this theory has been tested (e.g. Porter 1991; Priem and
Butler 2001). While examples of this tautological form of measurement
can be found, mostly in the popular business literature (e.g. Peters and
Waterman 1982), no high-quality research journal would publish this kind
of work. Even if there are some examples of this approach in the scholarly
literature—and we have not found them yet—it is clearly the case that the
vast majority (indeed, all) of the research reviewed in Chapter 11 has not
applied this tautological approach. Instead, it has developed independent
measures of resources and their capabilities and correlated them with inde-
pendent measures of performance.
This experience in testing resource-based theory suggests some lessons
about how to measure resources and their attributes. Many of these were
highlighted in Chapter 11. Despite the difficulties in measuring resources
and their attributes, the efforts of hundreds of scholars, summarized in
Chapter 11, suggest both that resources can be measured, and can be done
while avoiding tautological problems.

HOW IS SUSTAINED COMPETITIVE ADVANTAGE DEFINED?


Over the years, several different definitions of competitive advantage and
sustained competitive advantage have been published. However, after
fifteen years, a single set of definitions seems to be emerging. These def-
initions were presented in Chapter 1 of this book. The consensus now
seems to be that competitive advantage is said to exist when the economic
252 RBT: THE RESEARCH FRONTIER

value created by a firm in an industry is greater than the economic


value created by the marginal firm in that industry (Peteraf and Barney
2003). Economic value is defined by the difference between the willing-
ness of a firm’s customer to pay and that firm’s costs. Sustained com-
petitive advantage is simply a competitive advantage that lasts a long
period.
There is little doubt that these general definitions will have to be modi-
fied to be applied in particular empirical settings. Specific theoretical devel-
opments in resource-based theory, for example, game theoretic extensions,
may also require some modifications to these definitions. It may even be
the case that additional modifications of these general definitions may be
forthcoming (Postrel 2004; Lippman and Rumelt 2005a, 2005b). However,
to date, this approach to defining competitive advantage and sustained
competitive advantage seems to address many of the theoretical limitations
of prior definitions, and does so in a way that is amenable to empirical
test.
Interestingly, debates about how these two concepts should be defined
has not only led to clearer distinctions in resource-based theory, but has
also had an impact on the entire field of strategic management. In this
sense, not only are these two definitions applicable in resource-based the-
ory, they seem to be equally applicable to other strategic management
theories trying to understand why some firms are outperforming others.

IS RESOURCE-BASED THEORY TAUTOLOGICAL?


As Barney (2001) argued, it is always possible to restate any theory as
if it is tautological by failing to incorporate the parameterizations of the
independent and dependent variables of that theory in its restatement.
Thus, restatements of resource-based theory that fail to incorporate the
essential parameterization of this theory say nothing about whether the
theory is, at its heart, tautological (Priem and Butler 2001). Indeed, a full
statement of resource-based theory makes it clear that the theory is not
tautological—an assertion that seems to be supported by the numerous
empirical tests of implications of the theory summarized in Chapter 11.
This is especially the case since some of these tests generate results that are
inconsistent with some of the implications of the theory.
THE FUTURE OF RESOURCE-BASED THEORY 253

In its most general form, resource-based theory suggests that firms


with certain kinds of assets with identifiable attributes can generate sus-
tained competitive advantages. To give these assertions empirical content,
resource-based theory asserts that the kinds of assets in question are assets
that enable a firm to increase the willingness of its customers to pay for
its products and/or reduce its costs to a greater extent than at least some
other firms in this firm’s industry; that the attributes of these assets include
their path dependent, causally ambiguous, and/or socially complex nature;
and that a firm has a sustained competitive advantage when it is able to
increase the willingness of its customers to pay and/or reduce its costs to a
greater extent than at least some other firms in this firm’s industry and for
a relatively long period.
Note that the definition of competitive advantage (to increase the will-
ingness of its customers to pay and/or reduce its costs to a greater extent
than at least some other firms in this firm’s industry) is both in the
independent and dependent variables of resource-based theory. This leads
some to suggest that the theory is tautological. However, since competitive
advantage is on both sides of this theoretical equation, the only non-
tautological empirical assertions that are part of resource-based theory
focus on the attributes of resources (path dependent, causally ambiguous,
and/or socially complex) and the length of time a firm is able to sustain
a competitive advantage. This is why Barney (2001b) asserted that the
question of value is exogenous to resource-based theory, and that the
theory’s predictions focus on the relationship between certain attributes
of resources and how long a firm is able to maintain its competitive advan-
tages.
Can resource-based theory be stated as if it was tautological? Yes. Is
resource-based theory tautological? No.

Extending resource-based theory

While resource-based theory has been developed and extended broadly,


there may still be further opportunities to extend the theory in some mean-
ingful and important ways. Several of these possible extensions are noted
here. However, how resource-based theory can be extended ultimately
depends on scholarly creativity and innovativeness. What turns out to be
254 RBT: THE RESEARCH FRONTIER

the most important extensions of the theory may not even be mentioned
here.

ADDITIONAL EMPIRICAL TESTS


The most obvious extensions of resource-based theory will take place
through additional empirical tests of the theory. Particularly fruitful tests
are likely to have one or more of the following characteristics.2
First, future tests of this theory are likely to apply the quantitative case
study approach. Since the value of a firm’s resources depends so much on
the specific industry context within which a firm is operating, studies of
samples of firms in a single industry, perhaps over time, are most likely to
generate insights about how particular sets of resources generate sustained
competitive advantages or not. There is already an emerging tradition of
this kind of scholarship in strategic management. This trend seems likely
to continue into the future.
This does not mean that large cross-sectional research will have no
future impact on resource-based theory. For example, the variance decom-
position research summarized in Chapter 11 uses such data. However, on
balance, it seems more likely that quantitative case studies of firms in a
single industry over time have more potential to generate insights about
resource-based theory than large sample, cross-sectional work.
Second, future tests of the theory area are likely to involve comparing the
predictions of resource-based theory and other theories in strategic man-
agement. Indeed, this kind of comparative work has already been done.
While the variance decomposition stream of work did not generate explicit
hypotheses to be tested, it nevertheless did pit the explanatory power of
resource-based theory against the explanatory power of positioning the-
ory. Overall, firm effects seem to explain more of the variance in firm
performance than industry effects, although industry effects continue to
exist.
A similar approach has been adopted in research on the theory of
the firm. Poppo and Zenger (1998), Leiblein and Miller (2003), Leiblein
(2003), and Folta (1998) each derive some theory of the firm hypotheses
from several different theories, including resource-based theory and trans-
actions cost economics. Sometimes these theories are rivals, sometimes
THE FUTURE OF RESOURCE-BASED THEORY 255

they are complements. There is little doubt that this kind of research model
is likely to generate important insights, both for resource-based theory and
for other theories in strategic management.
Finally, there are some early indications that Bayesian methods may be
particularly useful in testing resource-based theory (Hansen, Perry, and
Reese 2004). Traditional statistical methods focus on estimating mean
effects—the average relationship between variables A and B. Resource-
based theory is not about the mean, it is about the unusual, the outlier.
Indeed, standard statistical practice suggests throwing outliers out of a
sample to generate more efficient mean-based statistics. Resource-based
theory suggests that, rather than throwing outliers out of a sample, we
should study them!
Properly applied, Bayesian statistics enable a researcher to not only
estimate mean effects, but also to estimate firm-specific coefficients that
describe how two variables are related for a particular firm (Hansen, Perry,
and Reese 2004; Mackey 2006). One study of the relationship between
diversification strategy and firm performance using Bayesian statistics was
able to show that sometimes related diversification adds value to a firm,
sometimes it destroys value; that unrelated diversification adds value to a
firm, sometimes it destroys value (Mackey 2006). This study was also able
to show why the coefficient that linked diversification strategy with firm
performance varied by firm. The results are consistent with resource-based
theory.
Currently, the number of strategy scholars who understand and can
apply Bayesian methods is quite limited. However, this may be one area
where there are significant opportunities to extend empirical tests of
resource-based theory.

MATHEMATICAL RESOURCE-BASED MODELS


Virtually all social science theory is originally explicated using words and
language. This language-based approach can last for some time and gen-
erate a significant amount of empirical research. However, despite the
many advantages of this type of theory—not the least of which is that it is
accessible to anyone who can read—language-based social science theories
have one enormous limitation: They are insufficiently precise.
256 RBT: THE RESEARCH FRONTIER

Language is a rich and textured medium. In skilled hands, its subtly


and nuance can be used to communicate rich meaning, sometimes com-
municating many more than a single meaning all at once. When Julius
Caesar, in Shakespeare’s play of the same name, says, ‘Yond Cassius has a
lean and hungry look,’ he is not actually commenting on Cassius’ phys-
ical appearance—though Cassius may, in fact, be lean and hungry. He
is saying much more about Cassius’ ambitions and how those ambitions
can manifest themselves in a person’s appearance. He is also talking about
himself, for he too is ‘lean and hungry’, even if in fact he is neither lean nor
hungry, and maybe a bit afraid—of Cassius, surely, but of himself as well,
and what he is becoming. He also is commenting on the state of ancient
Rome, where political civility has almost been replaced by the politics of
violence, where the traditional contest of wills has almost been superseded
by the contest of brute strength—thus the emphasis on Cassius’ physical
state and its looming presence. All this meaning, and more, in eight simple
words.
But this subtly and nuance is a problem for science. Science requires
precision, not subtly and interpretation and nuance. Many of the con-
troversies surrounding social science theories, including resource-based
theory, are due to the imprecision and multiple interpretations of language.
As the limits of our language are reached, it becomes important to restate
our theories, including resource-based theory, in rigorous mathematical
terms.
Of course, this is already beginning to occur. Important parts of
resource-based theory have already been translated into mathematical
models (e.g. Adner and Levinthal 2001; Makadok 2001; Makadok and
Barney 2001; Adner 2002; Adner and Levinthan 2002; Adner and Helfat
2003; Adner and Zemsky 2005, 2006). This trend is likely to accelerate.
However, this mathematical exposition of the theory is not a simple
restatement. The increased precision with which the theory can be stated
has several effects, one of which is to generate insights that could not be
generated with the verbal theory alone. These insights suggest empirical
implications of the theory worthy of further detailed analysis.
The great risk in trading verbal theory for mathematical theory is that
developing elegant models becomes a means unto itself. This is a wide-
spread problem in economics, a problem that even many economists agree
has adversely affected the field (Debreu 1991). However, with respect to
THE FUTURE OF RESOURCE-BASED THEORY 257

resource-based theory, we are a long way away from this concern. A great
deal of progress can still be made in the theory by a greater reliance on
mathematical formulations.

Expanding resource-based theory

Additional empirical work and reformulating resource-based theory in


mathematical terms are almost inevitable extensions of resource-based
theory over the next several years. Possible expansions of resource-based
theory, that is, efforts to take the theory where it has yet to go, are more
speculative in nature. However, in this speculative vein, several possi-
ble expansions of the theory are possible. Some of these are discussed
here.

WHERE DO RESOURCES COME FROM?


Resource-based theory takes the existence of heterogeneous firm resources
and capabilities as given and examines the impact of these resources for the
ability of firms to gain and sustain competitive advantages. The question
about where resources come from is only addressed in resource-based the-
ory to the extent that this process may have an impact on the ability of other
firms to imitate a particular firm’s resources and capabilities. Thus, history,
in general, and path dependence, in particular, are important attributes of
resources that can have an impact on how costly they are to imitate.
But in another sense, observing that a particular resource was developed
in a path dependent way is really just a label for our ignorance about the
micro-dynamics of resource development. Why a particular path in a path
dependent process was taken; why (or why not) this path is irreversible
and inimitable; the impact of paths not taken; and how the decisions
made by boundedly rational managers, leaders, and consumers affect the
evolution of a path dependent process are all issues we know relatively little
about. And what we know often takes the form of interesting stories—
organizational autobiographies—that are difficult, at best, to generalize, if
only because we can only tell such stories about the paths taken, and not
about the paths not taken.
258 RBT: THE RESEARCH FRONTIER

Ultimately, a complete resource-based theory of firm performance


would have to include a more general theory of this resource-development
process. Such a general theory would acknowledge the role of luck in the
development of resources (Barney 1986a), but would also recognize the
important role of managers taking advantage of their good luck to extend
their resource-based advantages.
One area of research that confronts a similar class of problems is entre-
preneurship (Barney 2001b). Entrepreneurship scholars are beginning to
confront the question of how do entrepreneurs assemble a set of resources
to exploit market opportunities when the nature of those opportunities,
and thus which resources are required to exploit them, may not be known
(Alvarez and Barney 2005). How firms are organized in this setting, how
property and decision rights are all assigned, and economic profits—if
they exist at all—are allocated, are all important questions in this context
(Alvarez and Barney 2004, 2005).
Some of these scholars suggest that there may be two fundamen-
tally different ways of solving this central entrepreneurial problem. Some
entrepreneurship scholars adopt the assumption that opportunities for
competitive advantage exist as objective phenomena, just waiting to be
discovered by unusually insightful individuals (Shane and Venkataraman
2000; Shane 2004). Other scholars suggest that opportunities do not exist
as objective phenomena, just waiting to be discovered, but instead are
created by the actions of boundedly rational individuals just trying to
improve their current situation as much as possible (Baker and Nelson
2005).
Of these two theories, the latter—creation theory—seems to be more
amenable to helping explain where resources come from, if only because
the former—discovery theory—adopts assumptions and an approach that
are closely aligned with traditional economic theory. Traditional economic
logic, of which resource-based theory is clearly a part, is good at examining
what should be done to exploit opportunities that are reasonably well
understood. It is less good at examining what should be done to exploit
opportunities that do not yet exist. In such settings theories of muddling
through (Lindbolm 1959), effectuation (Sarasvathy 2001a), and bricolage
(Baker and Nelson 2005) provide an alternative to economic logic that
resource-based theorists might be able to borrow in developing a theory
of where resources come from.
THE FUTURE OF RESOURCE-BASED THEORY 259

DYNAMIC RESOURCE-BASED THEORIES


A second possible expansion of resource-based theories might be to
develop truly dynamic resource-based models. Currently, the core theo-
retical assertions of resource-based theory are not dynamic: Firms with
certain kinds of resources will be able to gain sustained competitive advan-
tages. While the theory focuses on a variety of dynamic processes that are
created by these resources and the advantages they create, for example, the
dynamics of imitation, the assumption of much of the current theory is
that the resources and capabilities that give a firm a competitive advantage
are relatively fixed in nature.
Ironically, even dynamic capabilities versions of resource-based theory
are static in this sense. That is, the ability of dynamic capabilities to enable
firms to develop new capabilities is also assumed to be fixed. While the
capabilities a firm develops with its dynamic capabilities may be new, the
ability to create new capabilities is assumed to remain constant, and thus
dynamic capabilities resource-based models are actually no more dynamic
than other versions of this theory.
That resource-based theory is not terribly dynamic in its construction
should not be too large a surprise. After all, resource-based theory was
originally developed as an alternative (or complement, depending on your
point of view) to Porter’s positioning theory, and positioning theory is also
not very dynamic in its characterization of the competitive process. Yes, the
threat of entry is central to positioning theory, just as the threat of imitation
is central to resource-based theory. But barriers to entry—because they
are attributes of industry—are not assumed to vary much over time. This
stability makes the model tractable, both to guide research and teaching.
But it is obviously the case that just because rivalry, substitutes, new entry,
and so forth generate an attractive industry now does not mean that these
are fixed attributes of an industry, that attractiveness is an unchanging
attribute of an industry. And so it is with resource-based logic: That a
resource is currently valuable, rare, and costly to imitate does not mean
that it will always be valuable or rare or costly to imitate.
Resource-based theory does acknowledge this limitation. Barney
(1991a) for example argued that resource-based propositions hold only as
long as there are no Schumpeterian shocks in an industry (Schumpeter
1934). Such shocks can take what had been valuable, rare, and costly to
260 RBT: THE RESEARCH FRONTIER

imitate resources and make them either not valuable, or not rare, or not
costly to imitate. However, identifying such Schumpeterian shocks as a
boundary condition in resource-based theory hardly qualifies as a dynamic
expansion of the theory. Again, it is more a label for our ignorance about
these dynamics than an analysis of them.
In this sense, the dynamics of competition among resources is a tem-
poral extension of the first expansion of resource-based theory discussed
here: Where do resources come from? However, instead asking about the
source of resources, dynamic resource-based models will ask: Where are
a firm’s resources going next? In this sense, current resource-based theory
answers only the middle of the three existential questions asked in moral
philosophy: Where do we come from, why are we here, and where are
we going? Given resource heterogeneity, resource-based theory can explain
why some firms are currently able to outperform others. As to the genesis
or ultimate fate of these resources, resource-based theory has little to say.
However, it may well be the case that the theories that use entrepreneur-
ial actions to explain where resources come from may also help explain
how resources evolve in the future. This is a highly speculative suggestion.
However, since at one point the present was yesterday’s future, it might be
possible to take insights about how the past became the present to under-
stand how the present could become the future. Of course, the business of
predicting the next Schumpeterian shock is really the business of fortune-
tellers and futurists—and sometimes it is hard to tell the difference. But, it
may be possible to predict who is most likely to generate this shock, how
incumbent firms with incumbent resources are likely to respond, and when
new entrants will overtake incumbents. In this sense, Christensen’s work
(Christensen 1997; Christensen, Anthony, and Roth 2004) on the inno-
vator’s dilemma and using theoretical models to anticipate the evolution
of industries—and the value, rarity, and imitability of resources in those
industries—are early exemplars.

RESOURCE-BASED THEORY AND THE FIELD OF ECONOMICS


In the mid-1960s, it seemed inconceivable that finance scholars would
one day make contributions sufficiently important to the field of eco-
nomics so that they would be awarded the Nobel Prize in economics.
THE FUTURE OF RESOURCE-BASED THEORY 261

This happened the first time in 1985, when Modiglianni won the prize.
It happened again in 1990 when Markowitz, Miller, and Sharpe shared
the prize, and in 1997 when Merton and Scholes shared the prize. In this
sense, finance is an example of a field, originally dominated by practitioners
and largely atheoretical in nature, that matured to the point that it began
to make fundamental contributions to its discipline of origin, namely
economics.
It may seem inconceivable now that strategic management scholars
would ever be taken seriously enough by the field of economics that they
would be considered for the Nobel Prize in economics. However, this was
just as inconceivable for finance in the mid-1960s as it is for strategic man-
agement in 2006. Of course, it is not being suggested that strategic man-
agement, in general, and resource-based theorists, in particular, should
adopt ‘winning a Nobel Prize in economics’ as a realistic or worthy goal.
However, efforts to have strategic management research, generally, and
resource-based theories, in particular, taken more seriously by economics
would almost certainly have a positive impact on the expansion of both the
field and of this theory.
To facilitate this link between resource-based theory and economics, sev-
eral things must occur. Some of these are already occurring. For example,
mathematical exposition of the theory is likely to make it more attractive
to mainstream economists. Publishing theoretical (e.g. Adner and Zemsky
2005) and empirical (e.g. Henderson and Cockburn 1994, 1996) resource-
based articles in mainstream economics journals will also facilitate this
interaction.
One way that resource-based theory will probably need to expand if
it is to begin to have implications for broader discussions in economics
concerns the role of social welfare. Historically, strategy scholars have not
discussed social welfare at all (Barney and Hesterly 2005). This may have
been a matter of personal taste—after all, our major applied audience
was firms, not society at large. However, more fundamentally, the once
dominant paradigm in the field of strategic management—the position-
ing perspective—was derived from economic theory in such a way that
engaging in strategies to generate competitive advantages could generally
be expected to reduce social welfare. When client firms are taking actions
to reduce rivalry, tacitly collude, and to erect artificial barriers to entry to
retain their high profits, it is difficult for strategy scholars to contribute
262 RBT: THE RESEARCH FRONTIER

much to broader conversations about how to maximize social welfare.


Indeed, in this context, a good way to maximize social welfare may have
been to do away with the field of strategic management!
However, building on Demsetz’s observations (1973) about efficiency
explanations of heterogeneous firm performance, resource-based theories
have always held the potential for developing a theory of heterogeneous
firm performance that was also consistent with maximizing social wel-
fare. Such a theory could have a variety of important policy implications,
including implications for antitrust policy, patent protection policy, and
employment policy—to name just a few. Only a couple of efforts have been
published in these areas, and these efforts are tentative at best (Barney 2001;
Ellig 2001).
However, it does not seem unreasonable to suggest that this is a poten-
tial stream in resource-based theory that could be developed to a sig-
nificant degree. To the extent that proposed resource-based social poli-
cies differed significantly from policies derived from current economic
theory, these efforts might actually highlight the link between resource-
based theory to the broader economic and social policy issues of the day.
Such a linkage might benefit both the fields of strategic management and
economics.

Conclusion

Resource-based theory, like the resources it describes in firms, is a path


dependent phenomenon. Its evolution from earlier ideas and original artic-
ulation in the mid-1980s depended on specific individuals at particular
points in time making idiosyncratic decisions that, over time, came to be
known as resource-based theory. As with all path dependent processes, luck
and chance played a role. Alternative paths—perhaps even more fruitful
alternative paths—were rejected in favor of the path taken, although at the
time these decisions were made, the future of this theory—and of the field
of strategic management—could only be seen imperfectly, through a glass,
darkly.
Today, the theory stands poised to extend itself, both empirically and
theoretically, and to expand on itself, by asking and answering questions
that are beyond its current borders. This too will be a path dependent
THE FUTURE OF RESOURCE-BASED THEORY 263

process, full of uncertainty—the fits and starts of science—whose ultimate


destination cannot be known.
But however this theory develops, who will develop it can be known with
certainty—it will be the same eclectic group of scholars, curmudgeons to
the last, who will not take the status as quo. And in asking new questions
and challenging old ideas, we all benefit.

NOTES

1. Birger Wernerfelt first developed this name for the theory. It has always been a source
of some confusion since it is so close to resource-dependence theory in organization
theory, a theory with which it has nothing in common except the word resource.
2. These issues are discussed in more detail in Chapter 11 and are included in an
abbreviated form here just for logical completeness.
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INDEX

acquisitions see mergers and acquisitions benchmarking, and HR practices 134,


adverse selection, and trust 97 138–9
agency theory 185, 201, 221 Bethune, Gordon 133
airline reservation systems, IT and sustained Bettis, R. A. 20, 21
competitive advantage 147, 149, biotechnology industry, resources and
150–1 capabilities 179, 180–1
Akerlof, G. A. 95 Bossidy, Lawrence 132
Alchian, A. 132–3 Bowen, D. 124
Alcon Laboratories 122–3 Built to Last (Collins and Porras) 170
AlliedSignal 132
Allscheid, S. 124 capabilities
American Airlines, SABRE system 153 building 23
Amit, R. 23 and competencies 22–4
Andrews, A. 239 dynamic 23, 222, 230, 243, 249, 250
antitrust implications of economics 5, 12–13 and the future of resource-based
architectural competence 224, 225, 227, 243 theory 248–50
Argyres, N. 183 and vertical integration 165–83
Arthur, W. B. 60–1 capital markets, financial strength and
assets strategic factor markets 42–3
accumulating and managing invisible capital resources 24
assets 19–20 IT and access to 146–9
and imperfectly imitable resources 64 cash flows
invisible 170–1 and corporate diversification 188–9
mass inefficiencies 227 inimitable and uniquely valuable
organizational analysis of 46 synergistic 213–14, 215–16
and resource-based theory 253 private and uniquely valuable 210–13
stock interconnectedness 227 unexpected synergistic 215, 216
strategic assets and corporate Castanias, R. P. 18
diversification 198, 200–1 Caterpillar 61, 67, 68, 168
and sustained competitive advantage 48 causal ambiguity
tradability of 33, 37–44 and capabilities 170–1
attitude surveys of employees 123–4 and imperfectly imitable resources 62–4,
224
Banker, R. 144 CEOs
banks, research on sustaining competitive and distinctive competencies 6
advantage 227–8 individuals and team production 132, 133
Barnett, W. P. 227–8 and international strategies 236
Barney, J. B. 16, 17, 22, 24, 39, 59, 81, 93, 94, and listing as strategic analysis 50–1
154, 162, 168, 171, 188, 214, 222, 224, Choi, Y. R. 241
225, 226, 227, 228, 230, 247, 248, 249, Chrisman, J. J. 240
252, 253 Christensen, C. M. 260
Baumol, W. J. 52 Chrysler 132
Bayesian statistics 255 Clark, B. R. 86
308 INDEX

Cockburn, I. 223–4, 225, 227, 230, 243, Cool, K. 17, 38, 39, 64, 168, 189, 214, 226–7,
261 248
Collins, J. C. 79, 170 core competencies 21, 22, 24
Collis, D. J. 232 and corporate diversification 185, 186–91,
Comment, R. 188 198
commodity markets, and trust 97, 105 corporate control, as a strategic factor
compensation, and human capital market 32, 34
investments 195–6 corporate diversification 185–204
competence theories, of corporate competence theories of 19, 20–1
diversification 19, 20–1 and core competencies 185, 186–91, 198
competencies and economic value 223
architectural competence 224, 225, 227, employees and firm-specific
243 investments 189–98, 201–2
concept of 22–3 path of 198–9
and valuable resources 58 research on 234, 235
competitive advantage resources and market failures 186–9
defining in resource-based theory 24–9, and risk management 195–8
252, 253 scope of 199–201
empirical research on sustaining 226–9 corporate strategies, research on resources
environmental models of 58 and 234–5
and organizational culture 18, 81, 83–7, cost leadership strategy, and economic
90–1 value 223
resource-based model of 58 create-capture-keep paradigm 145–6
and strategic factor markets 31–48 creation theory of entrepreneurship 258
and sustained competitive advantage 52–3 creativity
and trust 105–18 costly to create resources and
semi-strong 106–8, 110, 116, 117 capabilities 168–71, 178, 180–1
strong form 108–15 and organizational culture 83
weak form 105 Crown Cork & Seal 6
and valuable resources 57–8, 59 culture see organizational culture
Wernerfelt’s theory of 14–15 customer needs, and performance of firms 4
see also sustained competitive advantage customer switching costs, and competitive
competitive disadvantage, and human advantage in IT 145–6
resources 129, 134
competitive imperfections, in strategic factor decision-making by list length 50–1
markets 33, 37–44 Deephouse, D. L. 232
competitive parity, and human resources Dell Computer 79, 90, 135
129 Demsetz, H. 13, 62, 132–3, 262
complementary resources and capabilities 67 development of resource-based theory 14–19
condition of duplication, and sustained developmental psychology, and trust 101–3
competitive advantage 53 Dierickx, I. 17, 38, 39, 64, 168, 189, 214,
conflict resolution 133 226–7, 248
Connelly, John 6 discovery theory of entrepreneurship 258
Conner, K. R. 18 Disney 170
Conoco 209 distinctive competencies 5–8
consumer surplus, and competitive diversification 29
advantage 25 dominant logic of firms, and intangible
Continental Airlines 124–5, 127, 133, 135–6, assets 21
137 Donaldson, L. 93
contractual governance devices, and trust 98, DuPont 126, 209
99–100, 106–7 Dyer, J. H. 244
INDEX 309

dynamic capabilities 23, 202, 230, 243, 249, Ermoliev, Y. M. 60–1


250 Evans, P. 22
dynamic resource-based theories 259–60 expanding resource-based theory 257–62
extending resource-based theory 253–7
early resource-based contributions 14–19
economic consequences, of HR factors of production, terms to describe 22–4
practices 136–8 Federal Express (FedEx) 123–4
economic opportunities, in strong form trust financial capital resources 24
exchanges 109–12 financial performance, and organizational
economic rents culture 81–3, 90–1
and competitive advantage 26–9 financial strength, and strategic factor
and strategic factor markets 33–4, 35, markets 41–3
36–7 firm endowments, and sustained competitive
economic value advantage 74
and competitive advantage 25, 26–8, firm profits, and competitive advantage 29
251–62 first-mover advantages 55, 71
empirical research on 222–5 five forces framework (Porter) 31, 51
of human resources 122–5, 129, 135–6 flexibility, and economic value 223
of organizational cultures 83–5 Floyd, S. 144
and strategic factor markets 43–4 focused business strategy 188
economics Ford 128
antitrust implications of 5, 12–13 Fortune 500 companies 133
and resource-based theory 260–2 founders of firms, and trustworthiness 103
economies of scale, impact of differential Frank, R. H. 101
levels of 243–4 future of resource-based theory 30, 247–63
efficiency expanding 257–62
and competitive advantage 25 extending 253–7
and superior firm performance 4, 29 issues no longer important 248–53
Einstein, Albert 221, 222, 245 mathematical resource-based
Eisenhardt, K. M. 23 models 255–7
empirical research 30, 221–46, 250
additional 254–5 General Electric (GE) 132, 145, 170
and Einstein’s theory of relativity 221, 222 general managers, as distinctive
examples of 230–45 competencies 5–7
testing resource-based theory 222–30 General Motors (GM) 107, 128, 166
organization 229–30 Godfrey, P. 221, 245, 251
sustaining competitive advantage 226–9 governance
value 222–5 semi-strong trust through 97–100, 102,
see also resource-based research 105, 106–8
employees and strong form trust exchanges 109–10,
attitudes and HR practices 123–4 111
and firm-specific investments 189–98, and vertical integration 163–4, 165–6,
201–2, 244 177–9
firm-specific versus general skills 130–2 see also hierarchical governance
entrepreneurship Grant, R. M. 18–19
resource-based research on 240–1 Greve, H. R. 227–8
and resource-based theory 258 Grossman, S. J. 100, 110, 111
environmental analysis, and strategic factor Gulati, R. 115
markets 45–6
environmental models of competitive Hamel, G. 20, 21, 22, 186
advantage 58, 60 Hansen, G. S. 18, 232
310 INDEX

hard-core trustworthiness see strong form resource-based analysis of 122–9, 140–1


trust implications for HR executives 135–40
Hart, O. 100, 110, 111 resource-based research in 238–40
Hatch, N. W. 244 and sustainable competitive
Helfat, C. E. 18, 243 advantage 129–35
Henderson, R. 223–4, 225, 227, 230, 243, systems versus single HR practices 133–5
261 teams versus individuals 132–3
Hesterly, W. 162 Huselid, M. A. 239
heterogeneity
and semi-strong trust through Iaccoca, Lee 132
governance 106–7 IBM 90, 132, 147
and strategic factor markets 35–7 imitability
and sustained competitive advantage 51, of culture 85–7, 90, 91
54–7, 69, 73 of human resources 126–7, 129
and vertical integration 166 of path-dependent firm resources 227–8
Hewlett-Packard 170 see also imperfectly imitable resources
hierarchical governance immobility, and sustained competitive
and corporate diversification 186 advantage 54–7, 69, 73
and strong form trust exchanges 111 imperfectly imitable resources 59–67, 70
and transactions cost economics and causal ambiguity 62–4
(TCE) 163–4, 178 and social complexity 64–5
high technology industries, resources and and substitutability 65–7
capabilities 179, 181–2 and unique historical conditions 60–1,
Hill, C. W. L. 22, 221, 245, 251 71
history of firms individuals
empirical research on performance and the labor pool 125–6
and 232 strong form trustworthiness of 101–3,
and imperfectly imitable resources 60–1, 112
71 and team production 132–3
resources and capabilities 169 industry attractiveness
Hitt, M. A. 22–3 Porter’s theory of 17
Hoffman, J. J. 242 and SWOT analysis 50
Holmstrom, B. 95 industry attributes, versus firm effects on firm
Hoskisson, R. E. 22–3 performance 231–2
human capital investments 189–98 industry structure, and performance
risk management of 195–8 advantages 3, 4
human resources (HR) 29, 121–41 information technology (IT) 29, 143–58
building organizational capability and access to capital 146–9
139–40 customer switching costs 145–6
comparison of HR practices with and economic value 224, 225
competing firms 138–9 implementation 143–4
economic consequences of HR and management information
practices 136–8 systems 241–2
economic value of 122–5, 129, 135–6 managerial skills 151–4, 155–6
and firm specific versus general and operations management 242
skills 130–2 proprietary 149–50
human capital resources 24 and sustained competitive
imitability of 126–7, 129 advantage 145–57
importance of 121 technical skills 149–50, 154–5, 156–7
organization of 128–9 value of 144–5
rarity of 125–6, 129 inimitable cash flows 213–15
INDEX 311

innovation management, resource-based lack of understanding, and strategic factor


research on 242–3 markets 43–4
innovativeness, and organizational Lado, A. 128
culture 83, 84 Lamont, B. T. 242
institutional leaders 10 land rents, Ricardo’s analysis of 5, 8–11
and distinctive competencies 7, 8 Lang, H.P. 188
insurance industry language, and mathematical resource-based
research on economic value 224 models 255–6
role of IT investments 154–5 leadership, transformational 6
intangible assets, and dominant logic of learning-by-doing skills 152
firms 21 legal constraints on acquisitions 172–3
intermediate governance, and transactions Leiblein, M. 183, 229, 254
cost economics (TCE) 163, 164 Lindell, M. 232
international strategies, research on 235–6 Lippman, S. 53, 59, 226
Intuit 172 listing as strategic analysis 50–1
investments Lubatkin, M. 205, 206, 207, 208
firm-specific 189–98, 201–2, 244 Lucent Technologies 61
in IT 146–9
transaction-specific 15–16, 164–5, 178, McDonald’s 79, 90
179, 182, 250 MacDuffie, J. 128
invisible assets 170–1 Mackey, A. 188–9
accumulating and managing 19–20 McMahan, G. C. 128
Ireland, R. D. 22–3 Mahmood, M. 144
Irwin, J. G. 242 Mahoney, J. T. 18, 162
isolating mechanisms, Rumelt’s theory of 16, Makadok, R. 23, 228, 232, 237–8, 243–4
17 management information systems,
Itami, H. 19–20 resource-based research on 241–2
management teams, and sustained
Japanese firms, resources and capabilities competitive advantage 63–4, 65–7, 74
169 managerial talent, and sustained competitive
Jarrell, G. 188 advantage 58
Jensen, M. C. 205–6, 207, 208 managers
job satisfaction, and service quality 124 and imperfectly imitable resources 63
Johnson & Johnson 170 IT skills 151–4, 155–6
joint venture agreements, and strong form and social complexity of firm resources 64
trustworthiness 115 and sustained competitive advantage 66
market failure, and corporate
K-Mart 145 diversification 186–9
Kaniovsky, Y. M. 60–1 market governance, and transactions cost
Karagozoglu, N. 232 economics (TCE) 163, 164
Kauffman, R. 144 market power, and superior firm
Kelleher, Herb 127 performance 3, 4, 29
Kettinger, W. 144 market uncertainty
Khana, T. 115 and investment in IT 147
knowledge-based theory 22, 250 and strategic flexibility 174–5
Kohlberg, L. 101, 103 market-based governance devices, and
trust 98, 99
labor market, and human resources 125–6, marketing, resource-based research on 240
128 Martin, J. A. 23
lack of entry, and strategic factor mathematical resource-based models 255–7
markets 40–4 Merck 135, 136, 138–9, 170
312 INDEX

mergers and acquisitions 29, 205–18 opportunity costs


acquisition of unwanted resources and and competitive advantage 28
capabilities 176–7 and trust 99, 111
and applicable capabilities 175–6 organization
bidding firms 208–15 empirical research on 229–30
comparative parity for 208–9, 218 of human resources 128–9
overestimating value of targets 217 organizational analysis, and strategic factor
superior returns to 209–15 markets 46
costly to acquire resources and organizational capability, and human
capabilities 171–7, 181–2 resources 139–40
diversification through acquisition 47 organizational capital resources 24
and economic value 223 organizational culture 29, 79–91
failure of 177 and competitive advantage 18, 81, 83–7,
impact of acquisition on resource 90–1
value 173–4 defining 80–1
interests of a target firm’s owners 173 economic value of 83–5
legal constraints on acquisitions 172–3 and financial performance 81–3, 90–1
leveraging resources and capabilities 177 and human resources 126–7, 139
relatedness hypothesis 205–8 imitability of 85–7, 90, 91
strategic flexibility and uncertainty 174–5 and imperfectly imitable resources 61,
microeconomics, and resource-based 63–4
logic 18 modified 88–9, 90–1
Microsoft 172 normative implications of culture
Miller, D. J. 183, 229, 254 research 87–90
mobility barriers, and sustained competitive rare cultures 84–5, 86, 87
advantage 55–6 and strong form trustworthiness 103–4
modified organizational cultures 88–9, valuable cultures 84–5, 86, 87
90–1 firms with 89–90
Montgomery, C. 205, 206, 231 firms without 87–9
moral development stages, and trust organizational theory and behaviour, and
101–3 sustained competitive advantage
moral hazard vulnerabilities, and trust 97–8 73–4
Muhanna, W. A. 154, 224, 225, 229 Otis Elevator 145

new product development, resources and Panzar, J. C. 52


capabilities for 175–6 Park, D. Y. 227–8
Nickerson, J. A. 232 path dependence 17, 262–3
Nieman Marcus 138 capabilities 168–9
Nobel Prize in Economics 260–1 and non-tradable resources 39
Nohira, N. 115 resources 227, 257
Nordstrom 125–6 and semi-strong trust 108
and strong form trust 113
operations management, resource-based and sustained competitive
research on 242 advantage 227–8
opportunism and unique historical conditions 60–1
and corporate diversification 190–1, Penrose, Edith, Theory of the Growth of the
195 Firm 5, 11–12
limited opportunities for 96–7 PeopleSoft 146
and transactions cost economics perfect competition
(TCE) 163, 164, 165, 178, 182–3 and acquisitions and mergers 209, 217
and trust 95–6, 110 and strategic factor markets 33–5
INDEX 313

perfectly imitable cultures, and superior reputation


financial performance 82 and semi-strong trust through
Peteraf, M. A. 18, 25, 248 governance 98
Peters, T. J. 79, 80, 82, 83, 84 and strong form trustworthiness 113
pharmaceutical firms, research on economic research and development (R&D) 135–6
value of patented drugs 223–4, 225 residual value, and competitive
physical capital resources 24 advantage 27–8
physical technology, and imperfectly imitable resource costs, and strategic factor
resources 64–5 markets 37
Pisano, G. 22, 23, 181, 230, 249 resource-based corporate
Podolny, J. M. 242–3 diversification 197–8
Poppo, L. 233, 254 resource-based model of competitive
Porras, J. I. 79, 170 advantage 58, 73–4
Porter, M. E. 3, 5, 13, 14, 17, 25, 31, 51, resource-based research 222–45
56–7, 84, 105, 192, 205, 222, 248, corporate strategies 234–5
259 economic value 222–5
portfolio theory 185 entrepreneurship 240–1
positioning theory 259 firm performance 232–4
postconventional morality, and trust 102–3 human resource management 238–40
Prahalad, C. K. 20–1, 22, 186 management information systems
principled trust 101, 103 241–2
producer surplus, and competitive marketing 240
advantage 25 operations management 242
product differentiation strategy, and strategic alliances 236–7
economic value 223 technology and innovation
product markets management 242–3
and competitive advantage 31–3, 47 resource-based theory
enhancing product reputation 34–5 development of 14–19
expectations of future value 35–7 and economics 260–2
productive resources, Penrose’s theory extending 253–7
of 11–12 future of 30, 247–63
profit maximizing, and strategic factor as tautological 252–4
markets 41 resource-picking 23
Pronto system 147 resources 23–4
proprietary IT 149–50 definitions of 248–9
psychological contract 130–1 firm resources and sustained competitive
Publicis SA 173–4 advantage 57–75
and the future of resource-based
quantitative case studies, and empirical theory 248–50
research 224–5, 228–9, 254 market failures and corporate
diversification 186–9
rare cultures 84–5, 86, 87 measurement of 251
rare resources and vertical integration 165–83
and corporate diversification 203 Ricardo, David 61
and sustained competitive advantage 58–9, analysis of land rents 5, 8–11
70, 71 risk management, and corporate
rarity of human resources 125–6 diversification 195–8
Ray, G. 154, 224, 225, 228–9 Ruback, R. 205–6, 207, 208, 209
Reichheld, F. 135 rules for riches 237–8, 248
relatedness, and mergers and Rumelt, P. P. 15–16, 17, 18, 53, 59, 226,
acquisitions 205–8 231–2, 247
314 INDEX

Sabel, C. F. 95 Southwest Airlines 79, 90, 126–7


Schlesinger, L. 124 Stalk, G. 22, 249
Schmalensee, R. 231 ‘sticking to one’s knitting’ 90
Schmit, M. 124 strategic alliances, research on 236–7
Schneider, B. 124 strategic assets, and corporate
Schumpeterian shocks 53, 259–60 diversification 198, 200–1
SCP (structure-conduct-performance) model strategic factor markets 16–17, 29, 31–48,
of firm performance 3, 12–13, 72 49
Selznick, Phillip 22 defining 32
analysis of distinctive competence 7–8 developing insights into strategic value 33,
semi-strong trust 97–100, 102, 105 44–6
and competitive advantage 106–8, 110, heterogeneous expectations in 35–7
116, 117 and perfect competition 33–5
semiconductor industry and superior firm performance 31–3, 47–8
empirical research on firm-specific and tradability 33, 37–44
investments 244 Strategic Human Resource Management 128
vertical boundary choices 183 strategic management 3
senior managers, institutional leaders and empirical research on 231–8
distinctive competencies 7, 8 Strategic Management Society 51
separation, tradability of assets and lack strategic theory of the firm 15–16
of 38–9 strategic value, developing insights into 33,
service quality, and job satisfaction 124 44–6
Sharma, S. 232 strategy implementation, research on 229–30
Shepherd, D. A. 241 strong form trust 100–104
Sherer, F. M. 233 and competitive advantage 108–15, 116
Shoemaker, P. J. H. 23 economic opportunities in trust
Shuen, A. 22, 23, 230, 249 exchanges 109–12
Shulman, L. E. 22, 249 and trustworthy exchange
Silverman, B. S. 232 partners 112–15, 116–18
Singh, H. 205, 206 of firms 103–4, 113
single business strategy 188 of individuals 101–3, 114
skills structure-conduct-performance (SCP) model
and firm specific versus general of firm performance 3, 12–13, 72
skills 130–2 Stuart, T. E. 242–3
learning-by-doing 152 Stultz, R. 188
managerial IT skills 151–4, 155–6 substitutability, and imperfectly imitable
technical IT skills 149–50, 154–5, 156–7 resources 65–7
Smircich, L. 85 superior firm performance
Smith, Fred 123 and distinctive competencies 5–8
Snell, S. A. 128 and the principles of resource-based
social complexity theory 17
and imperfectly imitable resources 64–5, sustained competitive advantage 49–75, 250
227 defining 251–2
and resources and capabilities 169–70 and firm endowments 74
social costs, and semi-strong trust through and heterogeneity and immobility 54–7,
governance 98–9 69
social policy, and antitrust regulation 12–13 and human resources 29, 121–41
social welfare, and sustained competitive and imperfectly imitable resources 59–67
advantage 72–3 and information technology 145–57
Sony 170 and organization of resources 67–9, 70,
Soon, S. K. 144 71–2
INDEX 315

and organizational culture 18, 61, 63–4, transformational leadership 6


79–91 trust 29, 93–119
and organizational theory and behavioural approach to 93, 94, 99,
behaviour 73–4 101
and rare resources 58–9 and competitive advantage 105–18
and social welfare 72–3 defining trust and trustworthiness 95–6
and SWOT analysis 49–50, 57 economic approach to 93–4, 99
timing of 52–3 and HR practices 133, 139
and trust 29, 93–119 semi-strong 97–100, 102, 106–8, 110, 116,
and the VRIO framework 29, 69–72, 73 117
see also competitive advantage strong form 100–104, 108–15, 116
SWOT analysis 49–50, 57 weak form 96–7, 102, 105, 115–16
synergistic cash flows 213–15
Ulrich, D. 124
TCE see transactions cost economics (TCE) unique historical conditions, and imperfectly
team production 132–3 imitable resources 60–1, 71
technical IT skills 149–50, 154–5, 156–7 uniqueness of firms
technology and organizational culture 85
and imperfectly imitable resources 64–5 and strategic factor markets 40
resource-based research on 242–3 United Airlines (United Express) 127
and sustained competitive advantage 53 Utility Analysis of HR programs 134
Teece, D. J. 16, 20, 22, 23, 187, 230, 249
theoretical antecedents of resource-based valuable cash flows, and mergers and
theory 4–14 acquisitions 210–13
antitrust implications of economics 5, valuable cultures 84–5, 86, 87
12–13 firms with 89–90
time compression diseconomies 17, 108, firms without 87–9
227 valuable resources
top managers, individuals and team and corporate diversification 203
production 132, 133 human resources 122–5, 129, 135–6
Tornow, W. 124 and sustained competitive advantage 57–8,
total surplus, and competitive advantage 25 59, 70, 71
Toyota 107, 166 see also economic value
TQM programs, research on 234 value chain, and sustained competitive
tradability advantage 56–7
and strategic factor markets 33, 37–44 value creation, and competitive advantage
lack of entry 40–4 25
lack of separation 38–9 value-creating strategies 24
uniqueness 40 vertical integration 29, 161–84, 233
training, in firm-specific skills 131–2 and economic value 223
transaction-specific human capital 133 and governance 163–4, 165–6, 177–9
transaction-specific investments 15–16, and opportunism 163, 164, 165, 178,
164–5, 178, 179, 182, 250 182–3
transactions cost economics (TCE) 161–4, resources and capabilities
221, 254–5 across firms 166–7, 180
and corporate diversification 187–8 costly to acquire 171–7, 178–9, 181–2
resources and capabilities 162–3, 165–83 costly to create 168–71, 178, 180–1
in firm boundary decisions 165–77 see also transactions cost economics (TCE)
in governance choices 177–9 ‘visionary’ firms, resources and
and trust 116 capabilities 170
see also vertical integration Vredenburg, H. 232
316 INDEX

VRIO framework 29, 69–72, 74, 81 Wiley, J. 124


analysis of human resources 122–9, 134–5, Williamson, O. E. 95–6, 146, 250
140–1 Willig, R. P. 52
Wilson, M. 128
Wal-Mart 67–8, 145, 153–4, 170 Woolridge, B. 144
Walters, Jack 122–3 Wright, P. M. 128, 131
Waterman, R. H. 18, 25, 79, 80, 82, 83,
84 Xerox, PARC (Palo Alto Research
weak form trust 96–7, 102 Centre) 68–9, 72
and competitive advantage 105, 115–16
Welbourne, T. 239 ZapMail system 147
Welch, Jack 132 Zenger, T. 233, 254
Wernerfelt, B. 14–15, 17, 18, 22, 231, 232, Zornitsky, J. 124
247, 248 Zucker, L. G. 103